Jamal Mecklai: Of dogs and tails

MARKET MANIAC

Over the past few months, "NDF arbitrage" (non-deliverable forward) has been the easiest whipping boy in the forex market whenever the rupee loses ground, and, indeed, there appears to be considerable evidence""both analytic and anecdotal""that this may well be the case.

Analytically speaking, the arbitrage available (by buying 1-year forward dollars onshore and selling in the NDF) has been very highly correlated""as much as 95 per cent over the past few months""with the movements of the spot rupee onshore. Indeed, whenever the arbitrage crossed 30-35 paise""first in late August, then in mid-October""the rupee fell sharply, falling below 44 the first time, and below 45 the second. (While correlations do not tell you about causation, a high correlation is certainly a necessary""if not sufficient""condition to accept a relationship.)

So, what is this NDF market and why is it doing these "terrible" things?

Well, the NDF market began in the early 1990s, as a result of investors' needs to hedge their risks in markets that had capital controls. Rupee NDFs were always a poor relative, since I guess, there really wasn't that much interest in hedging rupee risk""even as late as 2003, the liquidity in the rupee NDF market was a meagre $20-50 million a day (in comparison with, say, the South Korean won, which traded as much as $1.25 billion a day, and even the Chinese yuan, which traded around $250 million a day).

Since then, of course, the picture has changed completely. I met a banker the other day who told me that it is today quite easy to do volumes of $100-150 million of "rupee NDFs" in a single day, with a market impact of not much more than 4 or 5 paise; compared to the 2 paise or so impact such a transaction would have in the domestic market, this is pretty good liquidity. He also said there is a fledgling NDF options market, which has reasonable liquidity""not much less than the domestic options market. Clearly, India's dramatically enhanced global presence over the past couple of years is bringing renewed joy in Singapore and Dubai (where the bulk of rupee NDFs trade).

From this admittedly anecdotal information, it would seem reasonable to assume that on active days, rupee NDFs today probably trade close to $800 million to $1 billion a day, which is around 8-10 per cent of the volume of the domestic USD/INR market! Of course, NDF liquidity is very volatile and much of the time the volumes are nowhere near this level. But when they are, this, together with the high correlations I spoke of earlier, seems to be a clear sign of the tail (NDF) wagging the dog (domestic USD/INR).

You might ask, so what? Is this a bad thing?

Insofar as it reflects an increased interest by global investors in hedging rupee risk, I would say, to the contrary, that it's a good thing. There are more people interested in India""this is obviously a fact""and, since the local market is still far too controlled in terms of access, they are seeking out other ways to manage their risk. In the bad old days, when the forex market was completely controlled, we had a flush and thriving havala market. Now, while there's no denying that the forex market is much less controlled, the fact that NDF liquidity has been growing dramatically to the point where it is now noticeably impacting the domestic market (and the risk management efforts of its users) would suggest that it is time for further opening up. Global experience has shown that NDF liquidity shrivels away in currencies of countries that have allowed greater capital account convertibility to the point where currency hedging is fully available onshore. Of course, another way of looking at it is that the increasing liquidity in NDF markets represents an intermediate step on the road to capital account convertibility, and the RBI should welcome this growth, rather than trying to dampen in through verbal or inspection-based intervention.

On a broader basis, however, the NDF show raises further questions. Why, indeed, is this arbitrage available? Why are offshore investors bidding the rupee weaker than the domestic market? They were quite happy holding rupees in the 43.50-43.80 range for a long time, judging from the fact that the arbitrage spread remained less than 20 paise for nearly six months between March and August.

The most likely explanation is that by late August, the near-certainty of steadily higher US rates started influencing global risk appetites negatively, which, coupled with India's steadily rising current account deficit""not a bad thing at all, mind you""began to create a short-term softness in investors' attitudes to India. Ergo, several global analysts started looking at a weaker rupee, which, of course, started driving perceptions in the NDF market.

Clearly, users of the domestic forex market""i.e. companies with risk exposures""need to start paying more attention to NDF rates, and, just as clearly, the RBI needs to lose its frown about the NDF market, recognising it as an invaluable information resource on the road to capital account convertibility.

The author is CEO, Mecklai Financial.