India’s central bank doubles down on market that it despised

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A cyclist passes the Reserve Bank of India headquarters during a lockdown in Mumbai on March 27, 2020. MUST CREDIT: Bloomberg photo by Dhiraj Singh

India’s most ambitious attempt to influence how foreigners trade its currency slipped through with little fanfare two weeks ago.

On a day when the Reserve Bank of India executed an emergency rate cut and pledged $50 billion of liquidity, it also opened the way for local banks to trade non-deliverable forwards, a currency derivative often blamed as a tool for speculators.

The policy shift opens a new front for the RBI to manage volatility in the rupee, which plumbed to a record low during the coronavirus outbreak. The central bank, with foreign reserves worth about $475 billion, is taking a markedly different approach to peers like Malaysia and Indonesia, which have sought to lure offshore trading and hedging activities back within their borders.

This will help the RBI take “necessary action in managing volatility in both onshore and offshore markets through appropriate steps, including intervention through Indian banks,” said B. Prasanna, group head for global markets sales, trading and research at ICICI Bank in Mumbai.

NDFs, nominally a tool for hedging, are also popular with investors who want to bet on the future direction of a currency without taking deliveries. They’re often used in major financial centers in place of currencies that don’t trade round-the-clock. Some central banks have blamed them for causing sharp disruptions in local markets when spreads widen overnight.

And that’s what happened during the latest market turmoil spurred by the pandemic. The spread between onshore and offshore one-month dollar-rupee contract blew to more than over a rupee since March, compared with the below 10 paise seen normally, according to data compiled by Bloomberg.

“When the offshore INR moves to a large discount versus the onshore, the RBI, in theory, should be able to intervene via local banks in the NDF market to close that discount, said Jeffrey Halley, a senior market analyst at Oanda Asia Pacific Pte.

Intervening in offshore markets has its advantages. The market is net dollar settled, which means there’s no liquidity fallout in the local market. The RBI intervenes in the domestic market by buying and selling dollars through state-run banks.

Even before the RBI’s latest move, trading of rupee NDFs had surged, causing unease among India’s policymakers. The average daily trading volumes for rupee in the U.K. soared to $46.8 billion in April 2019, a more than fivefold jump from $8.8 billion in 2016, according to the Bank for International Settlements. That exceeded the $34.5 billion recorded in India at the time.

In response, India has been moving to make its onshore market more attractive and preparing to replicate these offshore centers within the country. India Inx, a local exchange, has regulations in place to launch forex-settled rupee futures and options in the International Financial Services Centre hub of the GIFT City in Gujarat state, while earlier this year the RBI enabled round-the-clock trading in the rupee.

That’s similar to what some of its peers in Asia have sought to do. While Malaysia banned trading of NDFs, Indonesia put in place a domestic non-deliverable forward market in 2018.

RBI’s policy shift has come as a surprise, Nomura Holdings Inc analysts wrote in a note. The extent and pace of any convergence between the two markets will depend on their fungibility and regulations, it said.

“Offshore banks are unlikely to fully embrace the entry of Indian banks if their main purpose is to act as RBI’s intervention tool,” Oanda’s Halley said.

An RBI panel had argued against giving domestic banks direct access to offshore NDFs, citing potential loss of domestic liquidity. Instead, it suggested replicating the offshore market locally. Twelve Indian banks have subsequently set up banking units in GIFT City.

The move should be seen in a broader context of attracting more capital, said Abhishek Goenka, chief executive at India Forex Advisors Pvt. Ltd. “India wants to get listed on international bond indices and moves like this and allowing access to exotic hedging products are steps at facilitating that.”

While the liberalization will allow banks access to a wider capital pool to offer clients better rates, risk management will be key for Indian lenders looking to dabble in offshore derivatives.

Banks need to have separate position limits for trading in NDF markets within their overall limits for better risk management, according to Usha Thorat, former deputy governor and chair of the RBI panel. “There are implications for monetary policy as it could hurt inflation management when we want higher interest rates to prevail,” she said.

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