Growing offshore rupee market limits policy action, says RBI

The Reserve Bank of India (RBI) on Thursday expressed concerns over the growing offshore dollar/rupee market and said it constrained policy actions aimed at maintaining order in the domestic market.

A large offshore market causes systemic concerns as flows arising out of offshore transactions may flow into the domestic foreign exchange market, thus increasing volatility. “Moreover, transactions in these markets are non-transparent and outside the regulatory ambit,” RBI said in a report.

Market players who don’t have easy access to the onshore market, actively trade in the non-deliverable forwards market, which makes the offshore market opaque. This increased its risk and prevented the central bank from tackling balance sheet adjustments and disorders caused by large one-way bets driven by market players, RBI said. As the onshore and the offshore markets were deeply interlinked, external shocks affected the domestic economy, the report said.

RBI said hedge funds and domestic and foreign multinational companies that actively participated in the NDF market were guided more by international factors than domestic ones, while building dollar positions. Although huge capital flows have been successful in filling the current account gap, the dominance of portfolio and debt flows over long-term inflows is a cause for concern.

Portfolio flows were prone to sudden halts and reversals that may cause instability in the market, the central bank said. So far this year, foreign institutional investors have invested over $38 billion in local equity and debt instruments. Increased correlation between global markets had increased volatility in the domestic equity and currency markets, RBI said. The rupee’s alignment with volatility in advanced markets carried the risk of higher hedging costs for the real sector, the report said.

Apart from domestic equities and foreign inflows, the rupee has also been taking cues from the movement in euro and other Asian currencies. Europe’s debt crisis and uncertainty over recovery in the US economy have increased the importance of global events for the rupee’s movements in recent times.

The dollar/rupee market showed a two-way movement in line with RBI’s policy of maintaining orderly conditions in the market, rather than targeting any level of the exchange rate, the report said. In 2010, the rupee ranged between 43.97-47.74 a dollar.