India is now a well-integrated with the world economy and moves in tandem with global developments, both on the economic front as well on the currency front. The far-reaching changes in the Indian economy since liberalization in the early 1990s have had a deep impact on the Indian financial sector. The development in the Indian foreign exchange (FX) derivatives market should be seen along with the steps taken to gradually reform the Indian financial markets. The resultant spurts in foreign investments led to substantial increase in the quantum of inflows and outflows in different currencies, with varying maturities. The reforms provided the economic rationale for the introduction of foreign exchange (FX) derivatives and risk management since then has under gone a paradigm shift.
Need for a dynamic foreign exchange (FX) market in India
With the dismantling of trade barriers, business houses started actively approaching foreign markets not only with their products but also to source capital and direct investment opportunities. India Inc today has reached the scale and size of the global order and several Indian organizations are today world leaders in their respective industries. Arriving on the global scenario subjects corporations to diversified revenue streams in various geographies, thus leading to invoicing in global currencies such as USD, GBP and EUR among others. Similarly, access to various borrowing mechanisms and debt markets has also led to increased non-INR exposure on books. The heightened volatility and inability to predict rupee movements in recent times has led to severe pain on the part of corporations, irrespective of whether they have chosen to hedge their foreign exchange risks or not. In India, there has been an increasing awareness for the need to introduce financial derivatives in order to enable hedging against market risks in a cost effective way. A dynamic foreign exchange market provides businesses with a spectrum of hedging products for effectively managing their foreign exchange risk exposures. As Indian businesses become more global in their approach coupled with globalization of trade and relative free movement of financial assets, risk management through a broad based ‘active and liquid’ foreign exchange market has become a necessity in India.
Current Scenario of Indian Foreign Exchange Market
In the recent past, periods of exchange rate stability have bred complacency. Importers were confident that the Reserve Bank of India (RBI) would intervene to halt any rupee decline where as exporters were of the view that the Rupee has always been over rated and that there is no way that it shall appreciate from the present value. This traditional mindset has kept companies away from hedging their exposures.
Due to the generic corporate reluctance, lack of information & technology and consideration of hedging as unwanted cost centres, companies involved in hedging have mostly gone the conservative way to hedge their exposures, i.e. by entering into forward contracts (FC) with banks, which have been the Authorized Dealers (AD) in foreign exchange Market in India. The limited use and general lack of interest in the available instruments can be explained by the fact that dependence on external sources of funding was limited and the external sector wasn’t really developed.
Going forward, companies do take cognizance of the importance of currency risk management; however, one is not certain how many of the companies are working towards building capacity to deal with this changing scenario. However, many firms still prefer to keep their risk exposures un-hedged as they find the forward contracts as cost centres. The problem is accentuated by the fact that in the Indian context the market for derivatives in India other than forward contracts is very shallow. Nevertheless, new financial derivatives have been allowed in the market to provide for exposures arising out of increased business activity in the external sector.
In the current formative phase of the development of the foreign exchange market, as we take a closer look at the initiatives taken by corporate enterprises, it would be worthwhile to provide indicative recommendations on the way forward:
- Make informed hedging decisions: The corporations are recommended to look strategically into their risk exposure and take prudent decisions in hedging. The hedging decisions should be backed by professional treasurers, an efficient back office and good forecasting techniques
- Introduce & use new products: Corporations are also advised to consider going for various new derivatives that are flexible and cost effective. In addition to the traditional “physical” products, such as spot and forward exchange rates, the new “synthetic” or derivative products, including options, futures and swaps, and their use by the corporate sector should be considered prudently. These synthetic products have their market value determined by the value of a specific, underlying, physical product
- Role of Banks: If we examine the role of PSU banks in FX risk management, we observe that although India has witnessed improvement in informational and operational efficiency of the foreign exchange market, this has happened at a halting pace. The banking sector is recommended to recruit specialized personnel for the job with latest technology to deal in the market. They should also endeavour to merge their money market and FX operation and treat it as a separate profit centre for better efficiency
I do believe that the aforementioned steps if implemented can definitely make the FX market deep and vibrant, which will make the working of the corporate sector easier in dealing with the currency exposure. The focus of next generation regulation in domestic securities market should be on inclusive growth, i.e. broad basing or deepening the market with more innovative products and technology for a sustained growth brought out through healthy competition. Whatever path the foreign exchange markets in India takes, it is necessary to keep it aligned with public policy objectives, as exchanges are the mechanism through which market capitalism survives.
Disclaimer: Views are personal