Why is the Indian rupee depreciating?

India is one of the emerging markets whose currencies have been affected by the US monetary policy, specifically the US Federal Reserve's policy of quantitative easing.  In the following analysis of this problem, Kavaljit Singh also highlights the role of the non-delivery forward (NDF) market, one of the offshore markets which have emerged in a liberalised global financial order.

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THE Indian rupee touched a lifetime low of 68.85 against the US dollar on 28 August 2013. The rupee plunged by 3.7% on the day in its biggest single-day percentage fall in more than two decades. Since January 2013, the rupee has lost more than 20% of its value, the biggest loser among the Asian currencies.

There is no denying that India is not the only emerging market experiencing a rapid decline in its currency's value. Several emerging market currencies are also experiencing sharp depreciation over the prospect of imminent tapering of the US Federal Reserve's quantitative easing (QE) programme. The South African rand and the Brazilian real touched four-year lows against the US dollar in June 2013. Except for the Chinese yuan and Bangladeshi taka, most Asian currencies have witnessed sharp depreciation since the beginning of 2013. Nevertheless, the Indian rupee has fared much worse than other emerging market currencies because of India's twin deficits - current account and fiscal deficits. Foreign investors are particularly concerned over India's bloated current account deficit (CAD), which surged to a record high of $88.2 billion (4.8% of GDP) in 2012-13. Despite a modest recovery in the rupee's value between 4 and 12 September, the investors remain wary of India's excessive dependence on volatile 'hot money' flows to finance its current account deficit.

Over the past several months, India's exports have considerably slowed down due to weak demand from traditional markets such as the US and Europe. High imports of gold and crude oil have pushed the country's trade and current account deficits wider. Gold and silver imports were nearly $33 billion during January-May 2013.

From capital glut to capital flight

There is ample reason for concern that capital outflows from India and other emerging markets will rapidly accelerate if the Federal Reserve decides to curtail its bond-buying programme. This move would lead to higher interest rates in the US and investors may dump risky emerging market assets in favour of safe havens.

Since the beginning of the QE programme, much of the money has leaked into emerging markets offering higher yields and better growth prospects. The emerging markets have been the biggest beneficiaries of  the Fed's loose monetary policy, which has pumped extra liquidity since the global financial crisis of 2008. According to the IMF, emerging markets received nearly $4 trillion in capital flows from 2009 to early this year.

The investors borrowed cheap short-term money in the US and invested in higher-yielding assets in India, Indonesia, South Africa and other emerging markets. This resulted in more money flowing into debt, equity and commodity markets in these countries. In India, many companies resorted to heavy borrowings overseas. The massive capital inflows also enabled India to comfortably finance its trade and current account deficits rather than addressing the structural aspects of the CAD.

However, this money will quickly leave India and other emerging markets when the tapering of the QE programme begins. Already, emerging markets are witnessing a huge outflow of dollars as investors have started pulling money out of bond and equity markets. Foreign investors pulled out a record Rs.620 billion ($10 billion) from the Indian debt and equity markets during June-July 2013. If the Federal Reserve decides to taper the QE programme, the liquidity withdrawal would continue to put pressure on the rupee over the next 12 to 18 months.

Other developments

There are a host of other factors which have added to the bearish sentiments on the rupee. Economic growth in India in the first quarter of the fiscal year (April-June 2013) slipped to 4.4% due to a contraction in manufacturing and mining. A sharp rise in domestic food prices has also put grinding pressure on the rupee.

Apart from economic factors, the rupee remains vulnerable to rising global oil prices and geopolitical tensions in the Middle East and North Africa. As the threat of US-led war against Syria rises, oil prices are expected to rise, which will further make it difficult for the Indian government to reduce the CAD since India imports over 80% of its oil.

The rise of the offshore NDF market

Amidst all these developments, the critical role played by the offshore non-delivery forward (NDF) market in determining the value of the rupee should not be overlooked. The rupee NDF market has mushroomed in key global financial centres with the liberalisation of trade and capital flows since the 1990s.

NDFs are over-the-counter (OTC) derivative instruments for trading in non-convertible currencies such as the rupee and the Korean won. The contracts are called 'non-deliverable' since no delivery of the underlying currency takes place on maturity. The counterparties settle the contracts on maturity by paying the difference between the spot rate [decided by the  Reserve Bank of India (RBI)] and NDF rate, usually in US dollars.

Since NDFs are OTC derivatives, the actual size of the market is not known but various surveys suggest that the trading volumes in the NDF markets are larger than in the onshore markets. According to a study by the Bank for International Settlements (BIS), the daily turnover in the offshore rupee NDF market was $10.8 billion in 2010, nearly 52% of the total turnover ($20.8 billion) in foreign exchange forwards and forex swaps.

The NDF market for the rupee is mainly concentrated in Singapore, Hong Kong, Dubai, London and New York. In recent years, London has become a key centre for trading in the rupee NDFs. According to FXJSC Semi-Annual FX Turnover Surveys, the average daily trading in rupee NDFs in London increased from $1.5 billion in 2008 to $5.2 billion in 2012, a jump of 250%.

As the NDF market is an offshore market, the Indian authorities have no powers to enforce regulations on it. Domestic banks and companies are not allowed to transact in the NDF market. The main participants in the rupee NDF market consist of commercial and investment banks, hedge funds, currency speculators, international subsidiaries of Indian companies and big diamond merchants.

Although the NDF market is primarily meant to provide a platform to companies to hedge their foreign exchange risk and related exposures, the dominant players in this market are the speculators (who bet on the movement of the rupee) and arbitrageurs (who exploit the price differentials between offshore and onshore markets).

The growing influence of the NDF market

Being a 24x7 market, the offshore NDF market exerts considerable pressure on onshore currency markets, particularly when the market sentiment is fragile on the rupee. Before Indian markets open for trading, the NDF markets in Hong Kong and Singapore set the price movement of the rupee. A bearish or bullish trend in the NDF market sets the tone for trading in the domestic rupee market.

An empirical study by an RBI staff member found that there are volatility spillovers from the NDF market to spot and forward markets in India. The study also found that the magnitude of volatility spillover from NDF to spot and forward markets has become higher after currency futures were introduced in India in 2008. This is probably due to large arbitrage taking place between futures and NDF markets, says the study.

In its latest Annual Report (2012-13), the RBI has acknowledged that there is a long-term relationship between the spot and NDF markets for the rupee. 'During the period of depreciation, shocks originating in the NDF market may carry more information, which gets reflected in on-shore segments of the market through mean and volatility spillovers,' states the report.

Foreign banks playing the arbitrage game

Since foreign banks and institutional investors are present in both onshore and offshore markets, they profit from huge arbitrage opportunities using the prevailing negative sentiments in the market. Such entities buy dollar-rupee forwards in the onshore market and sell forwards in the offshore NDF market. According to India Forex Advisors (a foreign exchange consulting and treasury management firm), a large demand for forward dollar pushes up the forward rate and thereby influences the spot exchange rate in India. As witnessed during July-August 2013, the increased speculative trading in the NDF market exacerbated volatility in both the spot and forward markets in India.

Primarily six foreign banks (namely Citibank, HSBC, Deutsche Bank, UBS, JP Morgan and Standard Chartered) are the key players arbitraging between the rupee NDF market and domestic markets. Besides, a few international subsidiaries of big Indian corporations and some diamond merchants are also engaged in arbitrage practice.

The way forward

To rein in rampant speculation and manipulative activities in the offshore NDF market, the RBI should initiate consultations with regulatory authorities in other jurisdictions, particularly Singapore. If India and Singapore can sign a Comprehensive Economic Cooperation Agreement on a range of issues including trade in goods, services, investments, intellectual property and dispute settlement, the RBI could also pursue a Memorandum of Understanding with the Monetary Authority of Singapore seeking regular information exchange and ensuring higher regulatory standards for banks and speculators active in the rupee NDF market in Singapore.                                                 

Kavaljit Singh works with Madhyam, a non-profit organisation based in New Delhi devoted to research and public education on economic and developmental issues. The above is an edited extract from a Madhyam Briefing Paper (No. 11, September 2013) published by Madhyam in cooperation with SOMO (The Netherlands). The full text is available at www.madhyam.org.in.

Rampant manipulation in Singapore's NDF market Singapore is the offshore hub for trading in the NDFs of key Asian currencies. In the wake of the Libor rate-fixing scandal, the Monetary Authority of Singapore (MAS) initiated a review of the process for setting rates for NDFs in September 2012. The investigations carried out by MAS found that traders from 20 banks communicated with each other through email and electronic messaging to influence the NDF rate-setting process run by the Association of Banks in Singapore. Some of the prominent banks found guilty in the rate rigging were UBS, ING, Royal Bank of Scotland, BNP Paribas, Barclays and Deutsche Bank. Based on its investigations, MAS took penal actions against banks for professional misconduct and unethical behaviour. Nearly 50 traders were suspended and guilty banks were asked to set aside additional statutory reserves (in the range of S$100-1,200 million) with MAS at zero interest for a period of one year.

*Third World Resurgence No. 276/277, August/September 2013, pp 34-36