Deepening financial markets

RBI must assess both risks and benefits of its recent moves

Coverage of last week's monetary policy announcement by the Reserve Bank of India (RBI) paid attention almost entirely to the higher than expected reduction in the repo rate. However, this statement also contained the bi-annual Part B of the monetary policy review, announcing regulatory and developmental measures relating to banking, financial markets and other domains in the RBI's jurisdiction. Of particular significance were several measures relating to foreign portfolio investment (FPI) in government securities, the freedom for Indian corporate groups to issue rupee-denominated bonds offshore, and an expansion of the list of eligible participants in the currency markets, both in exchange-traded and over-the-counter (OTC) products. On FPI investments, ceilings on FPI will now be set as a percentage of the outstanding stock of securities (five per cent), which should, according to the RBI, increase in stages the permissible amount by almost 80 per cent in rupee terms over the next three years. FPI will also be allowed into state development loans, with limits being increased over three years. As regards the currency market, registered primary dealers will be allowed to participate in the currency futures market, while the ceiling on hedging through OTC products through self-declaration by eligible resident entities has been raised significantly.

All these measures can be seen as significant steps down the road to full convertibility. Some of them also have implications for a broader financial market development framework. For example, higher FPI limits for investment in government securities bring another source of demand into the market at a time when banks are being gradually weaned away from the protection of mark-to-market exemptions on their Statutory Liquidity Ratio (SLR) portfolios. This will push them to trade these securities more actively; but, without incremental demand, potential price declines may deter trade. More FPI presence will certainly help in the short term. On the issuance of offshore rupee bonds, clearly, the borrowers will now be buffered from exchange rate risks, which the lenders will have to bear.

However, even as they explore the many benefits, direct and indirect, from greater convertibility and a broader market framework, policymakers must also naturally be conscious about the risks, which were brought into sharp focus after the financial crisis of 2008-09. First, India, like most countries, is experiencing what may be a prolonged decline in export earnings. Fortunately, soft commodity prices have nevertheless helped take the current account deficit (CAD) into a relatively safe zone. But declining exports do carry the threat of a sudden reversal in an unquestionably risky global environment. Second, if foreign lenders are to hedge their rupee exposures, the easiest place to do it now is the unregulated non-deliverable forward (NDF) market, which is both cheap and global. Greater activity in this market could pose some threats for an orderly onshore currency market. On the first issue, while the narrow CAD does provide an opportunity, vigilance and the will to act should the situation turn are necessary. On the second, in keeping with the direction of change in the currency market framework, every incentive must be given to lenders to hedge their currency risks on regulated markets, preferably Indian markets. Full capital convertibility has been a long-standing aspiration of the Indian policy establishment. As the economy moves inevitably towards it, policymakers must constantly assess benefits and risks.