Don?t make hedging opportunities more difficult for India firms
As India?s economy has soured, its currency has plummeted. The response of the Reserve Bank of India has been confused and counter-productive. Why do I make that claim? First, the fundamental value of the Indian rupee is determined by economic fundamentals. The rupee will recover when India does two things: put its macroeconomic house in order by controlling the fiscal deficit and inflation, and restoring its growth story through microeconomic and institutional reforms. These have little or nothing to do with RBI?s management of the exchange rate.
There are two counters to this claim. First, in the short run, the exchange rate can overshoot, and this can have harmful impacts on the economy during that period. Second, increased volatility of the exchange rate, which can accompany uncertainty about its level, is also harmful. The harm is that economic agents within India, particularly domestic firms, will suffer losses due to the fluctuations in the exchange rate or sharp movements in its level.
RBI has taken two types of actions to manage the rupee?s recent vulnerability. It has intervened in the foreign exchange market, and it has introduced new restrictions on trading in currency derivatives. Intervention is meant to directly counter private market participants? views, buying when they are selling, or selling when they are buying. Restrictions on derivatives trading are meant to reduce speculation in movements of the currency. These restrictions can also support the first objective, by raising the cost for private market participants to trade, and give RBI more weight as a trader in the foreign exchange market.
The problem with foreign exchange intervention, as has been shown repeatedly across the globe in the past few decades, is that it has limited power in the face of global capital market sentiment. A large amount of trading of rupee derivatives takes place offshore, and the value of the rupee will be determined by large economic actors in global financial centres. Recently, Kaushik Basu has advanced an ingenious theoretical argument for effectiveness of intervention based on credible commitment by a central bank when other traders are a competitive fringe, but it has yet to be tested empirically. I think instead that RBI has very limited scope to do much beyond managing day-to-day liquidity and unusually sharp short-term falls or spikes in the currency. Even if the rupee is falling below its fundamental long-run value, RBI has to accept the limits of its power to influence the level of India?s currency.
Restrictions on trading in currency derivatives are more problematic. Restrictions include those on who can trade, what can be traded, when trades can take place, and what net positions currency traders may hold. RBI issued circulars in December 2011 and May of this year, substantially tightening existing restrictions. The ostensible goal is to reduce speculation, though a hidden objective may also be to thin out the market and give RBI more clout. But large amounts of trading take place offshore, beyond RBI?s reach. Many of the restrictions simply hurt Indian financial institutions at the expense of foreign players.
The nature of the restrictions also makes it harder for Indian firms to hedge their currency exposures. As India has globalised, the need for managing currency risks of all kinds has increased dramatically. RBI has taken retrograde steps that will make it more difficult for effective hedging opportunities to develop for India firms, especially smaller ones that do not have offshore liquid assets in their treasuries?larger firms with such resources can again operate globally to manage their risks.
The argument that currency derivatives caused problems for Indian firms in the past is like saying that a toddler fell because the parents did not clear the floor of obstacles, so now he should not be allowed out of the crib. RBI?s December 2011 restrictions on cancelling and rebooking forward contracts raise hedging costs for Indian firms, even for the simplest kinds of forward contracts. Such hedging has nothing to do with complex derivatives that were being peddled just before the financial crisis.
Indian firms, and India?s economy, would be better off with an approach to regulation that moves away from piecemeal, ad hoc measures that fragment markets, reduce liquidity and prevent learning. Transparent exchange trading of basic currency derivatives such as plain vanilla forward contracts, without arbitrary restrictions on contracting or net positions, would allow Indian firms to develop effective hedging strategies. The onus of risk management at the firm level would be on corporate boards, which would also learn how to do their job. None of this prevents RBI from regulating to avoid systemic risks, such as dangerously large aggregate currency exposures for the economy. Making sure that the playing field of currency markets is level and visible to all participants is also an important regulatory job. Good regulation is difficult?bad regulation is easy.
The author is professor of economics, University of California, Santa Cruz
