Jamal Mecklai: Is RBI really growing up?

There's an old adage that goes, "It takes one to know one". In the context of growing up, this would mean that only a grown-up (whatever that is) would recognise and treat another person like a grown-up. And in this context, the RBI's apparent recent acceptance of higher volatility in the rupee does seem to signal that it recognises that Indian business has grown up or is growing up and doesn't need to be coddled and protected from the realities of life""i.e. the market.

While much public attention has been focused on the rupee's recent decline""and here I must add that it does appear that even our media is growing up, since they are much less hysterical about the rupee's over 5 per cent fall this year than they would have been even a year or two ago""the real news, at least to market maniacs like me, is that the average volatility of the rupee has risen steadily since June this year and currently stands at nearly 5 per cent. Unfortunately, market liquidity remains inadequate""measured by the fact that even at this higher volatility, the peak volatility (over the previous 90 days) is still nearly 25 per cent higher than the average. While these arcane numbers may make your eyes glaze over, they actually provide a simple indicator of how poorly the forex market is being managed.

Well-managed companies structure their businesses taking into account likely risks, and business processes are built to be able to manage those risks. Market risk is measured by the average volatility of the rupee, and if that volatility jumps around dramatically""and an analysis of other markets shows that 20 per cent over the average is a dramatic jump""it is likely to throw the company's planning out of gear, making running a business that much more difficult.

A very loud""and painful""case in point is the large number of companies that today are nursing near-lethal wounds, which were largely self-inflicted by entering into leveraged option positions. Several months ago""around July/August""when the rupee was quiescent around 43.50, the forwards were a mere 25-30 paise for six months, and sentiment was still bullish, dozens""perhaps hundreds""of companies succumbed to the lure of "well-meaning" banks who offered them a way to sell their exports at better than 44 rupees. Now while everybody knows there's no free lunch, this better-than-market rate was made possible by taking on the risk that if the rupee did fall beyond some preset upper bound, the company (a) would not only lose the opportunity provided by the market, but (b) would also have to make up the difference between the "better-than-forward-rate"""say, 44.25""and the then prevailing market. Today, the rupee is over 46, and there is, as I said, a lot of blood on the streets.

Now, in life, it is clear that if you ever take a beating, the first person to blame is yourself. The second, of course, is the person (or entity) who delivered the beating""here, you could blame the banks, your advisers, and, oh yes the market. But the market is ultimately a creature of God, and shaking your fist at the heavens is unlikely to provide much solace.

But, this is India, and let's see what blame, if any, can be laid at the doorstep of God's agent in this arena""the Reserve Bank.

Let's go back again to August this year. The rupee was at 43.50 and the six-month forward was at just about 43.75. Volatility was low""the rupee seldom moved more than 2 or 3 paise in a day""and the market had been more or less in this state since the start of the year. Further, sentiment was for continued rupee strength. A reasonable man, with an eye on his bottom line, could hardly be blamed for responding to the "attractive" offers from his banks that enabled him to improve on the measly forward rate of 43.75 or 43.80. The risk seemed minuscule""he would only stand to lose if the rupee fell below 44.50, which seemed extremely unlikely, given the state of the market.

Now, like I said earlier, the first person to blame is yourself for believing that you could get something for nothing. But, in my view, the RBI's narrow-minded approach to market development has""yet again""created the systemic risk reflected in dozens (maybe hundreds) of companies suffering multi-crore losses. It is hard to believe that the RBI didn't""and doesn't""know that, perhaps, its key job is to manage the pace of deregulation so that market liquidity is adequate to support the pace of economic growth. Greater liquidity, which can only come from deeper and wider markets, would result not only in higher volatility, which would render these leveraged products unviable, but also a lower peak to average volatility ratio, which would make risk management a sounder process.

Well, one of these is happening""rupee volatility is rising today. Perhaps, the RBI is, indeed, growing up.

My concern, though, is that the RBI's thinking still appears to be liquidity-neutral. For instance, it's back in a liquidity-crunching inspection mode, asking banks to report on and reduce their derivative exposures. Across the street, the RBI is proud of the "success" of the NDS in virtually eliminating debt market brokers, unconcerned about the negative fallout on market liquidity.

And, now, the government""once again""has set up a committee to look into creating a global financial centre. What's needed is a more active and much more market-savvy technical advisory committee to the RBI.