A global rupee may sound nice, but look before you leap

Prime Minister Modi’s global ambitions for the rupee hit a snag as RBI’s revised currency trading rules created a totally avoidable market panic.

Prime Minister Narendra Modi’s calls for globalising the Indian rupee have led to confusion and market turmoil, raising concerns about regulatory risks. | Photo Credit: Getty Images/iStockphoto

Speaking at the 90th anniversary of the Reserve Bank of India (RBI), Prime Minister Narendra Modi said it was time for the RBI to prepare a 10-year strategy to make the Indian rupee a global currency, one that was “accessible and acceptable” across the world. Extolled by the Prime Minister for his “out of the box” thinking, the RBI governor may have gone a step too far with that brief.

In somewhat awkward timing, the call to globalise was followed by a meltdown in the currency market as the RBI announced new rules on exchange-traded rupee derivatives, followed by a postponement of the new rules, prompted most certainly by the sharp response amongst brokers, proprietary traders, and analysts on the dangers of this move.

On the back of concerns around speculative trade, the RBI issued tweaks to its rules on trading currency futures or options asking people to sign a declaration confirming they have real exposure to the currency, so as to confirm that the trade is linked to a genuine transaction in foreign currency and not a speculative trade.

FEMA’s guidelines

The RBI justified its position by stating that the regulatory framework for participation in exchange-traded currency derivatives (ETCDs) involving the rupee adheres to the provisions of the Foreign Exchange Management Act (FEMA), 1999. According to these guidelines, currency derivative contracts concerning the rupee are permitted solely for hedging exposure to foreign exchange rate risks. The revised guidelines signify that the central bank would now permit exchanges to offer forex derivative contracts involving the rupee only for contracted exposure or hedging. This marks a departure from the current allowance, which permits up to $100 million of hedging without any explicit underlying exposure.

Following sharp criticism, a fair amount of time was spent at the RBI’s post-policy media briefing clarifying that there was no change in norms related to exchange-trade rupee derivatives. The moot point was that underlying exposure was mandatory for exchange-traded currency derivatives, said RBI Deputy Governor Michael Patra, while underlining regulations under FEMA. So, traders can take positions of up to 100 million dollars traders without demonstrating underlying exposure.

RBI Governor, Shaktikanta Das, explained that the central bank had decided to defer this decision by a month following requests from market participants for more time. In the meanwhile, retail traders made panic exits for their currency-derivative positions, brokers told clients to either submit proof of underlying exposure or unwind their existing positions, exchanges seemed wholly confused about the changes and shortly after the announcement, USD/INR April futures saw open interest drop by $833.6 million, or 18.5 per cent. In short, trading came to a screeching halt, with sizeable financial losses to many.

Seemingly caught in the cross-hairs of building and nurturing a thriving currency derivatives market versus FEMA guidelines that aim to check money laundering, the decision could potentially hit activity on exchanges and smaller retail traders. On its part, the RBI has said India’s underlying foreign exchange exposure is necessary for transacting in rupee derivatives on exchanges and that market participants have been misusing terms and conditions around relaxation in documentary evidence to imply there is no need for an underlying declaration, which is a violation of the law.

Estimates are that if this move comes into play, proprietary traders and individual investors, who make up over 70 per cent of the trading volume on exchanges will not be able to meet the underlying exposure requirement. According to India’s leading exchange for currency derivatives, the National Stock Exchange, corporates accounted for just 3.9 per cent of the currency derivatives turnover based on notional turnover in February while foreign investors contributed 6.2 per cent. Proprietary traders and individual investors were responsible for 80 per cent of the turnover.

Expected fallouts

Traders and experts were left scratching their heads about the whys of this move, but unanimous in their assessment that this would all but “kill” the currency derivatives market. Which would be a shame—introduced in 2008, exchange-traded rupee derivatives, have grown in leaps and bounds with average daily trading volumes on dollar/rupee futures climbing to $2.5 billion from $142 million in 2008, making this an important segment for India’s forex markets. It also leaves the small but influential segment of foreign portfolio investors or FPIs on unstable terrain and many have considered closing off any positions they may have had in the derivatives market, pending clarity.

The RBI’s decision draws a clear line between speculators or arbitrageurs and those taking hedged positions. While hedgers include exporters, importers and FPIs, it is the larger segment of brokers, traders and speculators that provide much-needed liquidity to the market. They are the grease that keeps the machine moving efficiently.

What we have now is not a recall of the decision but a deferral for a month, which essentially implies the sword of uncertainty continues to hang over the heads of those trading in the currency derivatives market. It is no wonder then that traders were advised to close their positions, pending clarity. Why would the central bank announce a change like this, that seems to be a hammer blow to exchanges?

After the RBI announced new rules on exchange-traded rupee derivatives, the currency market witnessed a meltdown. This was accompanied by sharp responses from stakeholders about the dangers of this move. | Photo Credit: Getty Images

A few possible reasons come to mind. Is the decision an acknowledgement by the central bank that it now wants to have absolute control over the currency market, ensuring that every rupee in and out passes through its lens. Or this is an attempt to rein in any large movement on the rupee?

On both justifications, there seem to be fairly specious arguments. Foreign portfolio flows for the financial year have been robust with $22.5 billion pumped into equities and $13.4 billion in debt. Numbers did dry up at the start of this calendar year, with FPIs selling Indian equities worth ₹25,744 crore but they have recovered in March, consolidating their position as net buyers in 2024 across equity and debt combined. Is the central bank not confident about the road ahead, enough to be rattled by the fear of sharp outflows? This, is when the central bank’s own foreign exchange reserves recently hit a record high of $642.63 billion.

Or, is it a heightened pitch to ensure the rupee does not wobble as much as it has, especially ahead of a high-stakes election? When the BJP won the general election in 2014, the exchange rate of the Indian rupee stood at Rs. 58.66 to a dollar. This week, the Indian currency slumped to a lifetime low, breaching the 83 mark to the dollar. Close to a 30 per cent slide in ten years.

Decisions such as the one on exchange-traded currency derivatives smack of a different approach altogether: control. Control over the movement of money, control over who can and cannot trade an asset, and control over the rise and fall of the rupee. While the first two may yet be achievable, in the case of the third, history and a lack of enough levers in place have shown that beyond a point, there is little the central bank or anyone else can do. Global movement on oil prices is not something the RBI or the government can control. A recent experiment comes to mind where Russia first agreed to take payment for oil in rupees only to quickly withdraw from the arrangement, not knowing what to do with the rupees they held in India. There also remains an inflation problem.

While some economists and the central bank have hailed recovering core inflation, it is equally true high prices of fruits and vegetables have ensured that inflation is still not in the RBI’s comfort zone, and that has played on the willingness to hold rupees. It is also a function of an oddly structured market, where the movement of capital flows into the equity and bond market is fairly free-flowing but not as easy while moving out.

It is no secret that our trade mechanisms are not global enough—India is not part of any noteworthy regional trade alliance, a move that could bolster the use and prevalence of the rupee. Featuring nowhere in the reserve currencies list at this point (the lion’s share goes to the dollar, followed by the euro, and a smaller share to the Japanese yen and British pound), the idea of achieving greatness for the Indian rupee is laudable in intent but unrealistic in the current landscape.

Alternate reason for turmoil

There could be another reason behind this fracas: ham-handed communication. Either the RBI was not clear about what it intended to achieve with its notice or the exchanges that ought to have been far more forthcoming and focussed on information around a large and active trading market were conspicuously missing in action.

The coming weeks will determine what the final call will be for traders with positions in currency derivatives. Going by the chorus of alarm bells the decision was met with, it appears clear that the central bank did not choose to hold any meaningful consultative process ahead of announcing these changes and that several features of the FEMA guidelines need remodelling.

What the events do leave is a bitter taste in the mouth—for policy clarity, for due consultations, and for a penchant to roll out changes only to quickly roll them back again.

It also underlines the number one red flag that trade and business in India comes with. As Nitin Kamath, co-founder of Zerodha, tweeted: “...regulatory risk is by far the biggest risk for stock brokers.” A giant leap for the rupee may have inadvertently become a wholly avoidable trip-up.

Mitali Mukherjee is Director of the Journalist Programmes at the Reuters Institute for the Study of Journalism, University of Oxford. She is a political economy journalist with more than two decades of experience in TV, print and digital journalism. Mitali has co-founded two start-ups that focussed on civil society and financial literacy and her key areas of interest are gender and climate change.