The size of the forward market is estimated to be roughly $1 billion Dollars a day.
Unlike fully convertible currencies, where only Interest Rate Differentials determine the level of forward premia/ discounts and expectations have no role, the forward premium on the Dollar versus the Rupee is a combination of the expected movement in the Rupee as well as INR-USD interest rate differentials. While there is no doubt that it was largely expectations which drove the forward market till as recently as mid 1995, there are now indications that some fundamental changes are taking place, pointing to a greater measure of capital account convertibility. In fact, with policy changes last year regarding foreign currency borrowings by corporates, the structure of the Forward market is undergoing a change.
The Forward Market Changes Color
The stage has been set for a structural change in the Rupee Forward Market - over time Forward rates will increasingly reflect Indo-US Interest Rate differentials.
In yet another commendable move, the RBI, announced on 19th October, ‘96 that banks can extend forex loans to Indian corporates from their FCNR(B) deposits. With this, the exchange risk shifts from banks to corporates - and paves the way for volatility to die out from the Forward market.
Since June 1996, several relaxations have been made on the external commercial debt front, which have a direct bearing on the constitution of the country’s foreign exchange market as well as on the liquidity in the money market. These changes are :
- Policy Guidelines for External Commercial Borrowings for 1996 -97 issued on 20th June, ‘96, allowed Indian companies to raise foreign currency loans between $ 3 and $ 15 million and utilise them for rupee expenditure as well. Earlier, forex loans were permitted only to pay for project imports. The forex risk on these foreign currency loans is obviously to be borne by the borrowing companies.
- FIIs have been permitted to invest all of their funds in corporate debt instruments, as against a ceiling of 30% earlier. The forex risk on such investments still remains with the investors, who are not permitted to hedge themselves against such risk. (This, incidentally, is a barrier to the Rupee becoming an internationally traded currency. A large degree of capital account convertibilty has already been ushered in.)
- The Busy Season Credit policy 1996 has allowed banks to lend their FCNR(B) deposits to corporates.
Since many of the corporates who will avail the FCNR(B) loans may refrain from hedging their forex risk, there will be little paying pressure on the forward premiums.
In any case, pure arithmetic (i.e. interest rate differential) is now expected to determine the level of forward premium, which should rule in the range of 6.0% to 9.0%, annualised, based on the following :
|1 to 3 Months (export finance)||6 Months (normal working capital)|
|Rupee cost of funds||13.0||16.0|
|USD Libor + Margin||7.0||7.0|
|Difference (cap on forwards)||6.0||9.0|
The Forward Market (See also : Hedging Instruments) is liquid upto a tenor of 6 months. In Q4 1996, the RBI officially permitted banks to offer quotes to their customers upto a 12 month tenor. While a few stray deals do take place in this segment, the market for "one year forward contracts" is yet to acquire depth and liquidity because : (a) On the demand side, importers perceive the cost (in excess of 7.5%) to be a little high and (b) Supply of forward Dollars from exporters is low because exporters are compelled to limit their receivables to a six-month period, both due to high Rupee interest rates as well as RBI dictat.
Over the next financial year, Forward rates are likely to come down.
|Forwards have stabilised in a 6.5-7.5% band, reflecting both stability in Spot Rates and interest rate differentials.|
|Reflecting expectations, premia, especially at the short end have risen, prior|
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