1. Dr. T V Nagendra Prasad, Charge d’ Affairs, Embassy of India, Mr. Phillipe
Welti, former Ambassador of Switzerland to India & Bhutan, Mr. Beat
Siegenthaler, Executive Director, UBS, Ms. Varsha Vasant Purandare,
Chairperson, Foreign Exchange Dealers Association of India (FEDAI), Mr. D. G.
Patwardhan, Chief Executive Officer, FEDAI, Mr. N. S. Venkatesh, Chairman,
The Fixed Income Money Market and Derivatives Association of India
(FIMMDA), Mr. C.E.S Azariah, Chief Executive Officer, FIMMDA, Mr. G
Mahalingam, Chief General Manager, Reserve Bank of India, and
distinguished delegates to the 7th Annual Conference 2012 of FEDAI.
2. It is a pleasure to be with you in this beautiful city of Zurich and discuss some of
the contemporary issues which are likely to pave way for the new order that is
being ushered in for creating a more robust, more transparent and less risky
financial sector. As you would be aware, a host of committees under the aegis
of the Bank for International Settlements (BIS), which is headquartered close to
Zurich in Basle, are rewriting rules governing the banking and market practices
and India is a part of most of these committees. The regulatory regime of the
international financial architecture is undergoing a metamorphosis post recent
global financial crisis. In this scenario, it is perhaps appropriate that a forum like
this reviews the relevance of the existing order, with particular reference to our
foreign exchange market, in the light of fast changing developments around us.
3. I shall start my address by revisiting the role of the FEDAI. I shall focus more
generally what should be the role of a Self-Regulatory Organization (SRO) in
today's context and particularly what should be the role of FEDAI in the
changed environment of our forex market. Moving over to some of the core
issues relating to the forex market in India, I will briefly touch upon some of the
recent measures taken by the Reserve Bank. Finally, I will briefly discuss the
issue of internationalization of Indian Rupee, a subject which is assuming
critical importance in the context of search for alternative reserve currencies
and the role for currencies of major Emerging Market Economies (EMEs) like
China and India.
Evolution of FEDAI in the changing environment of Indian forex market
4. As you may be aware, in the early post-Independence years, under the Foreign
Exchange Regulation Act (FERA), 1947, a few foreign banks, designated as
Exchange Banks were permitted to transact foreign exchange business. The
terms and conditions for undertaking such business were being laid down by
the then Exchange Banks’ Association. With the increase in India’s foreign
trade, several scheduled commercial banks were authorized by the Reserve
Bank to deal in foreign exchange business. This led to the formation of FEDAI
on August 16, 1958 with a mandate to lay down the terms and conditions which were mandatory in nature for the Authorized Dealers (ADs). With developments
in the Indian foreign exchange market and growth in external trade, the role and
responsibility of FEDAI underwent changes. I am happy to note that FEDAI,
through its members, continues to play a pivotal role in dissemination of the
foreign exchange related banking expertise across the country which has led to
significant improvement in the customer service.
5. Let me now highlight two important milestones in the evolution of Indian forex
market. In the year 1994, an Expert Group on Foreign Exchange Market in India
was set up under the Chairmanship of Shri. O. P. Sodhani, the then Executive
Director, Reserve Bank of India (popularly known as the Sodhani Committee).
The Committee had made wide ranging recommendations ranging from
methodology for correct computation of Open Exchange Position to introduction
of Rupee based options and these suggestions had laid the foundation for a
modern foreign exchange market in India. FEDAI played an important role in
supporting the Reserve Bank in implementing these pioneering measures and
suggestions aimed at major reforms in the market. The second milestone was
the replacement of restrictive FERA with the Foreign Exchange Management
Act (FEMA) in the year 2000. This provided further fillip to the development of
the foreign exchange market which can be gauged from the rise in the average
daily forex market turnover from approximately US$ 6 billion in 2000 to nearly
US$ 60 billion in 2010-11. This figure excludes the daily turnover in the
exchange traded currency futures market which would add up to another US$ 5
to 7 billion a day. The depth of the foreign exchange market can also be gauged
from the fact that the bid offer spread in USD INR pair is now around half a
paisa. The average daily foreign exchange turnover has, however, showed a
dip since the second half of December 2011. One plausible reason for the
decline could be the administrative measures taken by the Reserve Bank of
India to moderate the excessive volatile conditions prevalent in the foreign
exchange market but I will touch upon this issue a bit later in my address.
Future role and responsibilities of FEDAI
6. Having briefly touched upon the significant role played by the FEDAI so far, let
me now turn to the possible future role and responsibilities of the FEDAI with
special focus on should FEDAI become a full-fledged SRO.
7. Many countries rely on self-regulation because expansive resources are
required to regulate the financial markets effectively, especially in large and
complex markets. With the existence of an effective SRO, often referred to as
frontline regulator, the statutory regulator (the Regulator) relies on the SRO to
carry out supervision of operations and activities of the market participants. The
supporters of the idea of self-regulation claim that it offers significant advantage
over direct government/statutory regulation. This can be attributed to the fact
that SROs have thorough domain knowledge of their respective area and
regulatory framework within which they operate. Therefore, they are
considerably more flexible, context-driven and are able to respond faster to the
changes in market conditions. This also allows the Regulator to spare its
resources more on identifying and responding to major systemic risks and to
other priorities outside the ambit of self-regulation. It is believed that self-regulation system works effectively because of the business incentive to
operate in a fair, financially sound and competitive marketplace. The critics, on
the other hand, argue that private profit seeking enterprises cannot be trusted to
regulate their own activities as such self-regulation tends to create an illusion of
regulation. In addition to the conflict of interest, critics of self-regulation point to
certain other inefficiencies, such as, widespread collective action problems, lack
of effective enforcement capabilities, inability to gain or maintain legitimacy and
the failure of accountability.
8. Having weighed the views of the supporters and critics of the SRO system and
in view of the increasing complexities of financial markets and activities, it is
important to realize and emphasize that industry self-regulation cannot fully
replace government regulation and supervision of the financial services sector.
At the same time, it may not be out of place to say that co-operation amongst
the statutory regulators and SROs in an increasingly complex financial
environment is no longer an option but a necessity. Co-ordination and
communication should be structured to address potential problems before they
occur. One of the important regulatory lessons learnt from the recent global
financial crisis is the need for a concerted response. The Government or the
Regulator alone cannot provide an effective response. Active engagement of
market participants, in particular through industry organizations, such as, SROs
and other industry bodies with some self-regulatory capacity, is essential to
craft practical regulatory responses and to act effectively on policy changes.
9. In this era of fast paced liberalizations and developments, FEDAI should
gradually assume the role of a full-fledged SRO. Typically, a generic and
effective SRO in its template of elements cover, inter alia, internal rulemaking
process, authorisation and access to market-place, including
fitness/qualification standards for market intermediaries, surveillance of market
activities, administration of dispute resolution, sharing information and cooperating
with other SROs and the regulators, etc. SROs enable members to
exercise self-discipline, make regulations more responsive to market demand
and also promote innovation and development in a market based approach.
This is critical for the development of the financial markets in order to make
them competitive, regionally and globally, and improve standards of conduct by
self-regulation.
Developmental role of FEDAI
10. When the Reserve Bank issues instructions, it is expected that the instructions
are understood, interpreted and implemented in a uniform and customer friendly
manner by all ADs without building up system level stresses. In the absence of
unambiguous clarity of instructions to the base level official, the objectives of
various measures initiated by the Reserve Bank may not yield the desired
results. With the advent of FEMA which aims at facilitating external trade and
payments besides promoting orderly development and maintenance of forex
market in India, the economy has been witnessing rapid liberalizations. In such
a scenario, FEDAI needs to monitor the level of customer service and
consumer protection provided by its members and try to fill the gaps arising out
of inadequate knowledge or operational bottlenecks. The Reserve Bank has been emphasizing the need for designing some basic training module covering
the rules & regulations and also the operational guidelines for the frontline staff
at the branch and corporate office levels. Such a module will help them in
improving the foreign exchange related customer service, reduce incidents of
complaints and bring down the level of correspondence seeking clarifications
both within the bank and from the Reserve Bank. Member banks of FEDAI and
the Reserve Bank have since formed a Group which is working to develop an elearning
module to address these concerns. Another related area where FEDAI
is expected to play an important role is in framing of a Citizens’ Charter in the
area of foreign exchange business.
Role of market participants – freedom with responsibility
11. Let me now turn to the second part of my address, perhaps more relevant to
many in the audience in our current context.
12. An efficient market not only requires proper infrastructure, knowledge, skills and
enabling environment but also a great degree of market discipline reflected
through responsible behaviour by all the market participants. As was
experienced during the recent global financial crisis, among other reasons, the
greed of insensitive financial engineers for short term gains caused huge
financial and economic damages to some of the most developed nations and
markets. This has, in fact, become a major focus of discussions across the
jurisdictions after the financial crisis.
13. In the past, it has been argued that market discipline can play a key role in
incentivizing market participants to limit their excessive risk taking activities.
The events of the last few years, however, have proved the inadequacy of
market discipline. Bankers have been found to be actively engaged in risktaking
activities disguised as value-creation. Time and again market participants
have engaged in herd behaviour and put the financial system at risk, at times by
encouraging speculative build-up in the name of hedging for risk management.
The events of the past few years tell us that market discipline expressed via
market prices cannot be expected to play a major role in constraining risk
taking. Therefore, the primary constraint needs to come from regulation and
supervision. Since the ADs are the major players in the domestic foreign
exchange market in India, one would expect much higher responsibility from
them. Reserve Bank has come across instances where a few banks failed to
live up to that kind of expectations and have deviated from the ethics by misselling
forex derivative products which resulted in enormous problems for the
banks as also for the corporates some of which were carried away by the greed
of making money from activities other than their core business operations.
14. As you may recall, the existing guidelines on OTC foreign exchange derivatives
were revised in December 2010 in the context of developments in the
international and as well as the domestic markets. The revised guidelines put
more emphasis on the suitability and appropriateness aspects of products being
offered. Market-makers have been advised to undertake derivative transactions
with a sense of responsibility and cautioned to avoid, among other things, misselling.
These products are to be offered to corporates who understand the nature of the risks inherent and have a well laid down risk management policy.
Such policy must clearly lay down, inter-alia, guidelines on risk identification,
management and control, prudent accounting and disclosure norms and must
be capable of ascertaining the mark to market positions on an on-going basis.
In fact, the Reserve Bank has made it mandatory for the market participants to
offer a tool or a calculator which would enable the corporate to mark to market
these products on a continuous basis. Though the objective of the policy is
prudential in nature as it protects the market participant against the credit,
reputation and legal risks, it is important to realize that the policy protects the
interest of the corporates as well.
15. Let me also reiterate that banks need to closely monitor the un-hedged foreign
currency exposures of corporates as they had hedged approximately only 60
per cent and 38 per cent of their trade and non-trade related exposures
respectively till December 2011. Excessive risk taking by corporates could lead
to severe distress to them and large credit loss to the banks in event of sharp
adverse movements in currencies. In 2008, it was conveyed to the banks that
they should have a Board approved policy covering un-hedged foreign
exchange exposure of all the clients including Small and Medium Enterprises.
Banks while extending fund and non-fund based credit facilities to corporate,
should rigorously evaluate the risks arising out of un-hedged foreign currency
exposure of the corporates and price them in the credit risk premium as we
have recently reiterated in our circular following the announcements made in
the Second Quarter Review of the Monetary Policy 2011-12.
16. During the recent episode of excessive volatility leading to sudden and sharp
depreciation of Indian Rupee against US Dollar, it was noticed that the flexibility
given to banks for fixing their intra-day limits, which were in many cases,
significantly higher than their net overnight open positions limits, were often
being used for building up speculative positions and taking a directional bet on
Rupee. The facilities given to corporates by way of cancellation and re-booking
of their forward contracts and booking of forward contracts under past
performance criterion were also not being used in the right spirit. As you would
appreciate such speculative forces tend to be self-reinforcing and often result in
a situation where exporters keep on deferring their receipts and importers rush
in to buy forwards, thus aggravating the situation in hand. The administrative
measures undertaken by Reserve Bank in the month of December 2011 were
aimed at curbing these speculative behaviour of such entities. The measures
did achieve the intended policy objectives and also led to an immediate fall in
the volumes of the markets. The actual hedging requirements of the real sector,
however, were not left unattended as we subsequently relaxed some of the
measures to accommodate customer needs. Within the overarching prerequisite
of facilitating genuine hedging needs of the customers, Reserve Bank
would consider relaxations, in particular those relating to intra-day position
limits, in a calibrated manner at appropriate time.
17. Let me assure you that Reserve Bank will continue with its calibrated and
gradual approach towards liberalisation of the foreign exchange market in India
but at the same time we will expect greater degree of responsibility and
accountability from all the participants. In the context of our measured approach to market liberalisation, there has been a lot of debate on scope of wider usage
of Indian Rupee both in the region/abroad, or in other words, internationalization
of Indian Rupee. I will now briefly touch upon the issue in the third and last part
of my address.
Challenges for Internationalization of Indian Rupee
18. In view of the recent crisis in the financial market which resulted in a slowdown
in the world economy, some views have emerged from various quarters on
whether the Indian Rupee could play a larger role as an international currency.
This issue assumed a topical and, if I may add, patriotic significance when the
symbol for Indian Rupee was unveiled amidst huge media publicity. Proposals
for use of local currencies of the EMEs under bilateral and multi-lateral
arrangements including the initiatives taken by China for Yuan and the recent
suggestions emanating from BRICS nations have provided renewed focus to
this. It is a known fact that wide acceptance by participants in trade and
financial markets makes a currency a popular option for trade settlement and
for maintenance of reserves. The characteristics which a currency needs to
possess before it could become popular as a transactions currency would
include free convertibility, ability to invest, borrow, issue marketable
instruments, significant volumes of international trade in different regions,
stability of the exchange rate, the currency being a favoured choice for invoicing
which would, inter-alia depend on the mutual negotiating strength of trading
partners, availability of deep foreign exchange markets, cost-effective hedging
facilities including forward cover, availability of efficient banking
arrangement/market infrastructure, etc.
19. Based on the analysis of Prof. Peter Kenen of Princeton University, we can lay
down the following seven broad prerequisites for the process of
internationalization of a currency.
-
Domestic entities are permitted to invoice some of their exports in the
country’s currency, and similarly foreign entities are also allowed to invoice
their exports in that country’s currency;
-
There should be no restrictions on any entity, domestic or foreign, to buy/sell
its country’s currency in the spot and forward markets. In other words, there
should be freedom of foreign-exchange trading by domestic and foreign
entities and no limits be imposed on holding the domestic currency and
derivative instruments denominated in it;
-
Foreign entities/financial institutions/official institutions, and individuals, are
permitted to hold the country’s currency and financial instruments
denominated in it as a part of prudent investment strategy/the official
reserves;
-
Foreign entities, including official institutions, are able to issue marketable
instruments in the country’s currency. These may include both equity and
debt instruments, not only in the country’s domestic markets but also in
foreign markets, including, the home country markets of the foreign entities;
-
The issuing country’s own financial institutions and other entities are able to
issue in foreign markets instruments denominated in that country’s currency;
-
International and regional financial institutions are able to issue debt
instruments in a country’s market and use its currency in their financial
operations;
-
The currency may be included in the “currency baskets” of other countries, in
consideration of their own exchange-rate policies.
20. Measured against the above pre-requisites for internationalization of currency,
Indian Rupee is certainly far away from any meaningful internationalization. Of
course, a few measures taken in the recent years deserve some attention.
Since the introduction of FEMA, the Indian Rupee invoicing is a permitted form
of invoicing under the current trade and FEMA regulations. In order to facilitate
greater use of Indian Rupee in trade transactions, the Reserve Bank of India
has now allowed non-resident importers and exporters to hedge their currency
risk in respect of exports from and imports to India, invoiced in Indian Rupees.
In this regard, forward foreign exchange contracts with Indian Rupee as one of
the currencies and foreign currency – Indian Rupee options are the available
products for the purpose of hedging the risks. Non-resident exporter/importer
can avail of the facility either directly from ADs in India or through their banker
overseas. The AD, on the basis of the documentary evidence and undertakings
provided by the non-resident, has to be satisfied of the bona-fides of the
customer as well as of the transaction. As with all other hedging facilities
available to non-residents, these contracts once cancelled cannot be rebooked.
We would be happy to have your feedback on this particular measure
announced by the Reserve Bank of India as it is almost nine months since the
same was announced.
21. Eligible borrowers have been permitted to avail of ECBs designated in Indian
Rupee from their foreign equity holders under the automatic/ approval route. In
order to hedge the currency risk arising out of such ECBs, forward foreign
exchange contracts with Indian Rupee as one of the currencies, foreign
currency-Indian Rupee options and foreign currency-Indian Rupee swaps have
been permitted.
22. The debate on internationalization of a currency often goes hand-in-hand with
that on capital account convertibility. It is a known fact that capital controls can
co-exist with an international currency. Economic history is rich with examples
of countries, especially advanced countries with an international currency,
imposing a variety of capital controls to stem the depreciation/appreciation of
their currencies and/or to regulate short-term capital flows. While
internationalization of a currency is not a pre-requisite for capital account
convertibility, its large scale externalization has the potential to impose
significant costs, especially over the medium to long- term as the real and
financial sectors of a country grow and develop strong linkages with the world
economy.
23. The pace and the process of internationalization of a currency is of course
dependent on the acceptable degree of capital account convertibility. This, in
turn, involves the extent to which non-residents are allowed to participate in the
domestic forward foreign exchange markets to obtain cover and invest in the domestic markets for any Indian Rupee balances that they may accumulate. At
the same time, the benefits and costs of the Indian Rupee becoming an
international currency needs to be reckoned. The benefits broadly include
reduction of exchange risk for domestic exporters/importers as risks would
instead have to be taken by the overseas party and extensive use of Indian
Rupee by non-residents would mean increased seigniorage. Domestic entities
can also access international financial markets without exchange rate risk and
can avail of larger amounts of investment at a lesser cost than in the domestic
market. Expanded investor base and reduction in the cost of capital may help
both the financial sector intermediation and the real sector. Governments,
particularly those with high fiscal deficit, may benefit by foreign participation in
its debt market and get the benefit of higher flows to finance the current account
deficits. The costs would include difficulty in managing the implications for
monetary policy and exchange rate management besides the administrative
costs. Under the “Impossible Trinity” framework higher internationalization
would severely limit either the country’s flexibility to influence the monetary
condition, such as, interest rate, money supply. or manage exchange rate under
stress situations. Coming to the issue of benefit to domestic entities/government
by way of easy access to external resources, the huge risk in terms of
increased vulnerabilities arising out of sudden stops, panic outflows unrelated to
fundamentals of the economy, speculative bets by large pools of international
funds, loss of confidence in the context of size of reserves in relation to external
debt, particularly short term debt, have to be reckoned with. These
vulnerabilities have now been accentuated in the context of the recent global
financial crisis.
24. It is also imperative to understand that unlike countries with current account
surpluses, India generally has a sizeable quantum of current account deficit.
The exchange rate of Indian Rupee remains susceptible to ebb and flow of
external capital, especially outflows during periods of stress. Given the growing
level of our twin deficits of fiscal and current account hasty internationalization
could only add to our external sector vulnerabilities. As has been witnessed in
the past, sudden reversal of capital flow imparts significant volatility to the
exchange rate which at times needs to be curbed by the Reserve Bank. In the
event of internationalization of the Indian Rupee, the exchange rate would be
largely determined by the sentiments of the market forces and the present
policy measures to curb such volatilities may not prove to be as effective as
they are today. These are some initial thoughts on the subject which you would
be discussing in detail tomorrow. We would look forward to views/suggestions
that would emerge from the deliberations of the panel here and thereafter,
particularly if we can identify some low risk but macro-economically beneficial
areas, such as, progressive use of Indian Rupee in trade account given the
need to further boost to our exports sector.
Concluding thoughts
25. Economy and financial markets of India are in the midst of rapid transformation
due to its increasing linkages with the rest of the world. In keeping with the
changing needs, Reserve Bank of India has been striving for more
simplification, liberalization and rationalization of the policies and the processes in the area of foreign exchange administration without jeopardizing the financial
stability. Market-players, therefore, now have more freedom to undertake
transactions as compared to the earlier days. These flexibilities, however,
should be utilized in a responsible manner that is transparent, fair and beneficial
to the customers and the economy as a whole and not mis-utilized for short
term gains of a few market-players with adverse consequential effects on our
financial sector. Therefore, the role of FEDAI assumes greater significance in
the present context. There is, thus, a need to have a closer look at the working
and functions of FEDAI and strategize on how to transform it to a full-fledged
and responsive SRO. This would be a win-win proposition for all the
stakeholders including the banks, customers and the regulators like the
Reserve Bank of India. I am sure that the deliberations in this conference will
generate practical ideas on the future role of FEDAI, especially as we continue
to make progress in our calibrated approach towards capital account
convertibility coupled with the measures being taken to deepen and broaden
our forex market and facilitate greater use of Indian Rupee, particularly in the
trade account.
26. I wish you all the very best for productive business sessions followed by the
pleasure of exploring the sublime and scenic beauty of Switzerland.
|