Emergence of Indian currency markets: Issues and prospects

Abstract

The Indian economy has posted a stellar economic performance in recent years with a high growth of over 8 % for the last few years and is expected to be one of the major economies to look up to in the future. This would lead to increased foreign exchange operations in the country due to increased international trade and rising investment rate. Given these developments it is important that there be institutions to provide (a) Liquidity and (b) hedging opportunities to traders in the export – import market with respect to currency fluctuations. Presently, India has current account convertibility. Capital account convertibility is considered one of the major features of a developed economy and attracts further foreign investment. However a hasty introduction of capital account convertibility without adequately analyzing the downside risk could pose serious harm to the economy, as experienced in the East Asian economic crisis. We start by studying the impact of capital flows on the economy and the impact of the introduction of Capital Account Convertibility (CAC) ? studying both the risks and the gains of Capital Account Liberalization. We then look at the broad economic pre?requisites essential for safe Capital Account Liberalization. These parameters include inflation rate, exchange reserves and policy, tariff barriers & fiscal stability. The relation between capital account openness & inflation has been open to speculation, with theories supporting both the increase & decrease of inflation with introduction of CAC. Some economists argue that liberalization would increase capital inflows into the country leading to inflation, whereas others argue that the introduction of full convertibility would lower inflation by disciplining monetary authorities. It is important to study the path of liberalization taken by India in the past in order to ascertain the right time & the right methodology to adopt full convertibility. Creditably, India has maintained consistent inflows & has not had any major financial meltdowns, neither during the turbulent 90s, the turn of the century or the current economic meltdown. However, India has had only limited success in attracting FDI investment due to the stringent capital controls. The Tarapore Committee Report on Fuller Capital Account Convertibility provides a guideline for the gradual conversion to fuller capital convertibility. The committee recommends that a move to fuller CAC would need to derive synergies between monetary stability & an appropriate exchange rate regime, while negating the risk of large & sudden capital flows. With CAC, there will be a greater integration of the domestic economy with the global economy in addition to the enhanced linkages between the domestic money market, G?sec market, forex markets etc. The committee recommends limiting the Fiscal Deficit to 3.5 % and inflation rate to 3?5% for at least 3 years while maintaining a GDP growth rate of 8% for at least 5 years before embracing Capital Account Convertibility. With currency markets being operational in 2008, India is taking steps towards moving to a FCAC regime. The daily turnover in the currency markets is currently 11,000 crore which is only expected to improve going forward. There is already a NDF market for INR which is based offshore & settled in foreign currency which implies (a) we need a deeper rupee market (b) need to be more aggressive in promoting currency markets as a way to abolish the NDF markets which currently doesn’t add any value to local economy. The central bank & government are concerned about speculators in these markets and potential economic crisis as an effect of FCAC. However from our analysis & study we find having a large base of speculators is the best way to de risk the currency from high volatility. It is also important to understand the cause & causal relationship between currency convertibility & economic crisis. In most cases it’s the crisis which leads to foreign currency outflow rather than the other way down. A regression analysis of the relation between the stock market, global crude oil prices and the currency exchange throws light on the interrelationships between them. Together, the sensex & crude price movements explain more than 60% of the currency fluctuation. While both the stock market & crude oil prices affect the currency significantly, we find that the currency is more highly affected by the sensex and FII investment than by the crude oil price fluctuation. Comparing the interest rate volatility in India & the US, we realize the need to establish a strong & liquid debt market which would capture the true interest rate. In addition, the exchange rate would also have to satisfy the interest rate parity to avoid arbitrage opportunities. Further analysis of the relationship between interest rate & INR, and the variation of foreign currencies reveals that following the introduction of the USD market, the introduction of a Euro market than a GBP market in the Indian context would be more profitable. While on one hand FCAC dos bring in lot of risk into the system, it also has its own benefits. FCAC would reduce borrowing cost, improve diversification & lead to better hedging options for corporate. Therefore given the current global conditions and inherit structural flaws it is better that we move gradually towards FCAC rather than opening it up in a hurry however steps need to be taken to move in this direction.