Rupee: level vs volatility

The new currency regime that the RBI is following has led to new difficulties for individuals and firms. Two things have happened at once: The level of the rupee/US dollar has shifted from Rs 45 to Rs 41 per dollar, and the volatility of the exchange rate has gone up. The first effect inflicts pain on some (exporters) and pleasure for others (importers and the broad population). The second effect inflicts pain on importers, exporters and financial firms. The unhappiness about the shift in the exchange rate is not surprising. When diesel prices shift to their free market level, diesel consumers will obviously not be pleased. However, it is increasingly clear that it makes sense for monetary policy to focus on inflation control and not on targeting the exchange rate.

An entirely distinct story is the shift in volatility. The new currency regime represents a qualitative change from an RBI-controlled rate to a market determined exchange rate. The footprint of currency risk runs far beyond direct imports and exports. For, a large number of commodities are now priced by "import parity pricing", where the local price is just the exchange rate multiplied by the world price, even if the producer and consumer are both Indian. Importers, exporters, financial firms and households are taken aback at this upsurge in volatility. This concern is legitimate.

The existing currency forward market does not pass muster, for numerous reasons. It is a non-transparent market, where substantial fees are transferred from users to financial firms. The non-transparency induces poor price discovery, something that India can ill afford at a time when well-functioning spot and derivatives markets on the currency are the need of the hour. The opacity of the existing forward market is a recipe for scandal, and this fear of scandal will continually generate a bias in the government to prevent this market from gaining adequate liquidity. Currency risk is present in every corner of the country, while the currency forward market takes place only in south Mumbai. There is a clear way out which addresses all these problems: that of establishing transparent, exchange-traded markets for both spot and derivatives on the currency, so as to match the market quality of the equity market.

In an ideal world, the finance ministry should have better planned the transition of the currency regime. First, the currency spot and derivatives market should have been built up, and only after these structures for trading and insurance were in place, currency volatility should have been permitted to go up. Such planning has, alas, not been done. It is, yet, not too late to urgently move on establishing new market structures through which individuals and firms can do better risk management. The Mumbai International Financial Centre report has proposed two key initiatives in strengthening the currency market: Establishment of a currency spot market, with a "market lot" of Rs 1 crore, accessible to all financial firms, and establishment of a rupee-settled currency futures market, accessible to all. The ministry needs to make up for lost time by rapidly executing on these two ideas, harnessing the strengths of Sebi, the NSE and the BSE. Rupee volatility like that seen in mature market economies must be accompanied by the tools found in mature market economies for coping with currency volatility.