Notwithstanding the debate on the costs and benefits of a “managed” currency for an emerging economy like India, the RBI must not seek to manage the rupee’s volatility through an indiscriminate expansion of its regulatory powers.
The Indian rupee follows a managed floating exchange rate regime. This means that the central bank intervenes in the foreign exchange market to buy or sell dollars in order to stabilise the value of the rupee. In recent times, however, the RBI seems to be using its regulatory powers to gain greater control over the rupee. We argue that currency management must not entail the use of regulations. The purpose of regulations is to address market failures. Currency volatility is not a market failure — it is the fluctuation of the currency in response to demand and supply forces. The use of regulatory powers for currency management introduces uncertainty in the central bank’s currency policy, and also increases the cost of doing business in RBI-regulated sectors. We discuss three such regulatory measures and the problems associated with them.
First, prohibiting speculative trades on exchanges. This exacerbates the difficulties of taking rupee exposure in India. In 2008, the RBI allowed Indian exchanges to launch a currency derivatives segment. At that time, the RBI’s guidelines on currency Futures and Options allowed Indian residents to participate in this market “to hedge an exposure to foreign exchange rate risk or otherwise”. While the RBI continued to prescribe the product design, position limits, and trading hours, the general trend was towards opening up this market. The idea was that as India became more globally integrated, the demand for such instruments and for liquidity in the derivatives market would increase. At some point, the 2008 guidelines were overtaken by several circulars, with the last version issued in 2016 having been amended at least 11 times. These regulations explicitly allowed taking positions in rupee-linked currency derivatives up to $100 million across all exchanges, “without having to establish existence of underlying exposure”.
Earlier this year, however, the RBI explicitly mandated exchanges to inform users that they “should be in a position to establish the existence of a valid underlying contracted exposure, if required”. This warning compelled the bulk of retail traders to wind up their positions as a result of which trading volumes collapsed by about 80 per cent across all exchanges. This regulatory measure essentially restricts speculators from trading in the onshore rupee market. It overlooks the fact that a liquid market requires all kinds of traders, including speculators, who act as de facto market makers. This move is an irreversible blow to a reasonably liquid market, which allowed hedgers to take positions on the rupee at low costs. It is likely to drive away volumes to the offshore currency derivatives market.
Second, regulating offshore trading platforms. The RBI proposed to regulate offshore electronic trading platforms (ETPs), which facilitate rupee-linked derivative transactions. Published on its website in April 2024, this proposal seeks to empower the RBI to oversee the offshore currency forwards market, commonly called the non-deliverable forwards (NDF) market. The NDF market allows people to trade in the rupee without undertaking any physical delivery of the currency, thereby reducing the cost of trading. In the last few years, the rupee NDF market has grown substantially in size, and is now reported to be almost thrice as large as the onshore market. This has led to concerns in the RBI that the offshore market, over which it has no direct oversight or control, could be playing a significant role in determining the rupee’s value. The recent regulatory proposal requires ETPs to register themselves with the RBI, and confers fairly extensive powers on the central bank, such as the power to refuse registration, seek information, specify “eligible instruments” that Indian residents may trade in, and impose additional terms and conditions.
Legally, the RBI can restrict Indian entities’ rights to deal with non-residents or to transact in foreign currencies, but it is a jurisdictional leap to regulate offshore platforms on which Indian residents trade. This is akin to Sebi asking the New York Stock Exchange to register with itself, simply because Indian residents trade at these venues. Instead of expanding its regulatory powers, the RBI must make it easier for people to trade the rupee in India. This will help bring back rupee linked trading volumes and allied businesses onshore.
Third, the RBI’s instructions to banks. Earlier this month, when the rupee-dollar exchange rate depreciated close to the 84 mark in the spot market, the RBI is reported to have orally instructed some large commercial banks to not add to their existing trading positions against the rupee. This step seems to have been taken to stem further rupee depreciation. On August 16, the RBI similarly instructed banks that handle trade with the United Arab Emirates to partially settle their trade payments using rupee instead of the dollar. This means that banks should directly convert rupees into dirhams and vice versa without first converting them into dollars. One objective of this move seems to be to reduce dollar dependence in international trade. But settling trade in rupee also helps insulate the currency from the impact of dollar outflows, that is, lower the extent of rupee depreciation against the dollar. In other words, this is yet another regulatory measure that helps to manage the currency.
Notwithstanding the debate on the costs and benefits of a “managed” currency for an emerging economy like India, the RBI must not seek to manage the rupee’s volatility through an indiscriminate expansion of its regulatory powers. Regulations are the rules of the game. Unlike market operations that involve central banks buying or selling the currency in the foreign exchange markets, changes to the rules of the game can have a more permanent, damaging effect on the incentives and the costs of doing business in the country.
Sengupta is associate professor of Economics, IGIDR and Shah is a doctoral researcher at the National University of Singapore
