A year ago, I started a column on this topic in India’s Financial Express newspaper with the following:
“In December 1996, US Federal Reserve Chairman Alan Greenspan raised the concern that stock prices had been unduly lifted by ‘irrational exuberance.’ The US government acted swiftly, banning stock market trading until speculation had been eliminated.”
If that had really happened, it would have been quite something. My point was that US regulators and government officials had a very different approach to dealing with bubbles and crises than their Indian counterparts. Program trading was not banned after Black Monday in October 1987. Hedge funds were not banned after Long Term Capital Management collapsed. Given what has happened in the last year, one could argue that regulatory responses in the US have been too anemic, but there is hardly a case for outright bans on markets that are potentially well-functioning.
In India, on the other hand, certain kinds of markets or trading are simply prohibited. Recently, one policy response to inflation has been to ban futures trading in certain commodities, despite the lack of any evidence that it was contributing to the run up in food prices.
In the case of currency futures, offshore “non-deliverable forward” markets have existed for some time, and the Reserve Bank of India also oversees domestic currency forward trading. But exchange traded currency futures were simply banned. In June 2007, trading of rupee futures started on the Dubai Gold and Commodities Exchange (DGCX), prompting the RBI to set up a committee to look into this possibility for India.
Last year, I looked at rupee futures trading on DGCX, and despite the fact that it was not controlled by the RBI, so there were no restrictions on trading and participation beyond those that would be normal for an exchange (minimum lot sizes, rules for settlement, etc.) the market appeared to be functioning very well. Data on trading is available on the web, and one can track prices, volumes and open interest. It seemed pretty clear from the data that the new market was being used for short-term hedging, probably by parties engaged in international trade. I noted then: “the market is orderly, it provides information to all, and it allows participants to manage their risks as they see fit. But the rewards [for running the market] are accruing to Dubai, and not to anyone in India.”
I concluded my piece with: “The RBI’s proper role is macroeconomic management, not microeconomic details of running markets. This does not mean lack of monitoring or failure to manage crises. The key point is that macroeconomic management is unlikely to be compromised by enriching the set of financial markets in India. The latter, in turn, is crucial if India is serious about financial sector development.”
Recently, the RBI’s committee reported its recommendations for setting up exchange-based currency futures trading in India. The recommendation was for going ahead, which is greatly welcome, but with all sorts of (sometimes strange) restrictions. The announcement of guidelines was made earlier this month by the RBI and the Securities and Exchange Board of India (SEBI), which regulates the major stock exchanges.
As usual, Ajay Shah has a cogent critique of the unnecessary restrictions in the proposed trading set-up, though it is still a step forward compared to no market at all. There is a nice list of the policy mistakes in Shah’s piece:
“There are five mistakes in the launch:
- Derivatives trading on currencies other than the dollar is prohibited. At a time when China is pushing for futures trading of the yuan outside China, which would have been an ideal opportunity for us to have traded rupee-yuan and dollar-yuan contracts, we have gone in the wrong direction.
- Options trading is banned.
- FII participation is banned.
- NRI participation is banned.
- Positions larger than $5 million are banned – a tiny limit when compared with the size of exposure that is found in a trillion dollar economy”
Shah goes on to suggest that despite the limitations, the internationalization of India’s economy will ensure that the new market takes off.
Just to see if the plan for the new market is having any impact, I took a look at the Dubai exchange volumes and open interest figures for recent weeks, and for the same period last year. It’s probably too soon to tell, however. The Dubai numbers seem to be idiosyncratic, and the market is relatively thin. Trade volumes seem to have gone down compared to last year, but this could simply reflect lower uncertainty – recall that last year saw some unexpected swings in the rupee-dollar rate, as the RBI seesawed between exchange rate targeting and inflation control. Open interest was higher earlier this summer compared to last year, but recent activity has been minimal. It may well be that once the Indian exchange gets going (and fuller participation is allowed), Dubai will see little action. This may have some interesting implications for strategic planning for Mumbai’s possible role as an international financial center. My suggestion is to keep watching these developments. Here, for those interested, are the data I collected manually. Note the short-term nature of the action – more than a month out, volumes and open interest are almost always zero (I’ve given just a few examples and omitted the rest), and trivial otherwise. Lat year I looked at price data, but haven’t this time. Someone could easily write a program to grab all the data and do some solid analysis of the Dubai market in rupee futures. I hope a graduate student will do that.