INR trading outside India

INR-USD futures trading will start in two months in Dubai. I'm reminded of the Nifty futures, which first started trading at SGX, an event which probably had something to do with SEBI giving out permissions to NSE to trade Nifty futures.

If you have the MIFC book handy, I'd like to point you to (a) Page 127 which has the chronology of the license-permit raj in the story of Nifty futures trading; (b) Page 56 which has a full page box about Indian underlyings trading outside the country; (c) Page 46 which has a treatment of Dubai; (d) Page 152 on exchange vs. OTC trading; (e) Recommendation 45 (page 200) talks about rupee-settled currency futures.

MoF and RBI face the choice between having MCX/FT run an INR/USD currency futures market with DIFC regulation, or having an INR/USD currency futures market in India with SEBI regulation. With the huge growth of outbound FDI, a lot of Indian companies have global operations, and can place important risk management activities outside the countries. If the status quo - of currency futures trading being banned - continues, liquidity will increasingly shift to the INR NDF market or to this new currency futures product.

The edit in Financial Express says:

It had to happen. The Indian economy is becoming a powerhouse. So, too, the rupee. Ergo, the world becomes interested in the currency, and lo and behold, a world market for it emerges. How does such a market work? Suppose someone has an export contract payable in rupees two months from today. He can hedge the transaction against the payment going down in value against other currencies, by entering into a futures contract. It does not take an expert to tell us that such a market is critical for banks, traders and for anyone who deals in the Indian rupee. That tribe is growing pretty fast on the back of a rapidly globalising economy, with exports rising frenetically. Such transactions are critical to global financial markets, recording a daily turnover of about $270 billion. The scope of fee-based income for banks participating in these markets can be easily imagined. Yet, such a market is not permitted in India. So, it is hardly surprising that a foreign financial centre—in this case Dubai—has decided to plug the gap. Mumbai should have been the natural market for such contracts. According to reports, MCX has tied up with the Dubai Gold and Commodities Exchange to launch futures contracts on the Indian rupee to be operational from mid-June. Under RBI rules, such contracts may not be legal. But in this case, the RBI can hardly do anything, as contracts will be settled in US dollars.

With the rising profile of the Indian rupee, there has already been sporadic forward trading in derivatives with the rupee as the underlying tradeable unit in markets across the world (mostly non-deliverable, inter-bank deals). But since a futures contract is exchange traded, it is a superior financial product, and a transparent one, too. What’s more, as the RBI builds up a large defensive position on the rupee, the scope for hedging through a futures market in rupees has shot up dramatically. The biggest beneficiary of the new market will be Indian corporates, who are now increasingly exposed to global currency fluctuations. But, and this bears repetition, which financial centre should have led this move towards rupee trading sophistication? Mumbai, surely.

Today (17/4), there's an interesting story on this by Sanjiv Shankaran in Mint, where he says:

The government is considering introducing trading in rupee futures contracts on stock exchanges, a move that will bring the country a step closer to full convertibility of the rupee on the capital account of balance of payments.

Accordingly, the finance ministry will be asking the Reserve Bank of India (RBI) to explore the possibility of putting this in place at the earliest. Futures contracts are a commitment between two parties to effect transactions at a preset price and date.

The move is expected to usher in unprecedented transparency and liquidity in the country’s foreign currency market. At present, Indian corporates and banks hedge their foreign exchange positions through forward contracts in an over-the-counter (OTC) market, which are decentralized markets, unlike stock exchanges where all orders are matched electronically and in a transparent manner.

The finance ministry has decided to revisit the idea after the Dubai Gold & Commodities Exchange (DGCX) last week announced it would list rupee futures contracts in June, the first time a rupee futures contract will be traded on an exchange.

Allowing similar trades on an Indian stock exchange requires just an executive notification and no legislative changes, said a senior official of the finance ministry, who did not want to be named.

Indian stock exchanges can offer futures contracts, which can be settled at the time of expiry in rupees, the official added. Unlike DGCX’s rupee futures contracts, which are to be settled in US dollars.

The finance ministry wanted to make a broad policy announcement on the introduction of rupee futures contracts in stock exchanges during the course of the finance minister’s budget speech in 2006, said the official. The announcement did not take place as RBI felt the market was not yet ready to trade in rupee futures.

The DGCX move is a sign that RBI needs to loosen controls as forces beyond its control would begin to influence India, said Jamal Mecklai, CEO of Mecklai Financial, a forex advisory. “You cannot control markets when they start doing things outside what you are permitting,” he said. “It (DGCX’s move) is a loud sign that you need to accelerate your deregulation several notches; if you don’t, you will not only lose business to other centers but, far more important, you will have bouts of unmanageable volatility in your domestic market which will make it progressively more difficult for Indian companies to manage risk.”

There has been a historical precedent where external developments have prompted the government to fast-track its policy. In 1995, the National Stock Exchange (NSE) asked the capital market regulator, Sebi, for permission to start trading in stock index futures. Permission did not come through quickly and on 24 May 2000, Singapore’s SIMEX chose the Nifty, the exchange’s benchmark index of 50 stocks, for derivatives trading on an Indian index. Sebi then allowed NSE and the Bombay Stock Exchange to trade in index futures the next day.

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The global currency futures market, though small when compared to a currency forward markets, is still very significant. Despite forward markets accounting for the maximum trade volumes, some studies show that 85% of price discovery in forex markets are on account of futures markets, said the recent report of the high powered expert committee which looked at ways to transform Mumbai into an international financial centre.

What RBI wanted

Monetary policy transparency in India is very poor. It's only today - 12th April - that we find out the truth about what the monetary policy was in the month of February. We find that RBI purchased a HUGE $11.9 billion on the currency market - roughly Rs.52,000 crore. That's what I call pouring fuel into the inflationary fire. The implementation of the pegged exchange rate in February, with very little currency flexibility, came at the cost of an inflationary monetary policy. A few weeks ago, when I had written a piece titled `What RBI wants', there was an element of reconstruction of what was going on from fragmentary data. Now the data is out and we know just how bad it was.

Monetary policy regimes break down when the political costs of upholding the regime become unacceptable. In India's case, the INR appreciated from 44.2 to 42.8. Did the people who care more than RBI about inflation pick up the phone? How will things play out from here? In a non-transparent monetary policy regime, one does not know what is going on, or why. Monetary policy is one more stochastic process that economic agents have to cope with.

Day zero of implementation of the New Pension System

PFRDA has come out with a big announcement:

India's pension fund regulator Tuesday said it will push ahead with its planned reforms and have a pension fund operational by July, which will help reduce government liability and provide long-term funds to build the country's infrastructure.

"We have moved far ahead (on reforms in pension sector). We have identified National Securities Depository Ltd. as the central record keeping authority and will soon call bids to appoint fund managers," D. Swarup, chairman of the Pension Fund Regulatory Development Authority, said at a pension seminar.

He said the regulator will appoint three fund managers by the end of May to manage the pension funds of about 500,000 federal and state government employees, who joined the rolls from Jan. 1, 2004.

These employees, who come under the new pension system, will contribute 10% of their basic salary to the pension fund and an equal amount will be given by the government. National Securities Depository will track the pension contributions of these employees, said Swarup.

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The government had proposed to introduce a pension bill in parliament more than two years ago, but hasn't been able to move forward due to opposition from its communist allies.

Until the final bill is approved by parliament, neither private pension fund managers nor foreign direct investment will be permitted in the sector.

...

Swarup said the corpus of the 500,000 employees is estimated at INR17 billion ($396 million) and will be operational by July.

S. Narayan has an opinion piece in Mint on this, and Andy Mukherjee has written on Bloomberg.

Securities lending on the stock market

Securities lending on the stock market is one of the areas where the Budget Speech of 2007 has promised work this year. Mobis Philipose has an article Plugging the hole in Business World on this.

A difficult time for Monetary Policy

Monetary policy in India has continued to lurch from one difficult situation to the next. Last Friday, after the market closed, RBI came out with a series of monetary policy decisions even though it was not scheduled to be an MPC date. A stream of interesting reading has appeared on the subject.

On Monday morning, Ila Patnaik wrote an article in Indian Express and there was an edit in IE at the same time. The stock market dropped 5% that day - the RBI announcements were clearly bad news for India. Update (9/4): Former RBI Governor S. Venkitaramanan has written an opinion piece in Hindu Business Line responding to this.

Rajiv Malik has written a piece Poorly timed shock therapy in ET. FE had a good edit about the decisions. Jaideep Mishra has a plea for transparency of monetary policy.

When monetary policy fail to deliver the goods on price stability, politicians are distraught and think of listening to quacks - the UPA has come up with a series of supply side interventions. ET has three good pieces on this by Amit Mitra, Shubhashis Gangopadhyay and Partha Mukhopadhyay.

What do I think?

1. I think there is no tradeoff between growth and inflation in the long run. It is perfectly feasible to have stable 3% inflation and 9% growth for a decade. If anything, I think that high inflation and high inflation vol will drive down GDP growth.
2. I think the acceleration in the CPI-IW from 3% in 2004 to nearly 7% today is hugely disappointing and that it is very important to obtain stable 3% inflation. With this inflation vol, the long-dated INR bond market is doomed, which has many disturbing consequences for the financing of long-term projects in India - long term projects will be forced to hold low leverage or engage in original sin (i.e. currency mismatch). Update (14/4): Financial Express has an edit on this dimension.
3. I think that real rates remain too low to slow down inflation.
4. Thus I would be happy with a monetary tightening, if it were done.
5. I think it isn't being done. (See my piece What RBI Wants in BS today.)

All in all, it has been an unhappy set of weeks for RBI. As the editorial in Economic Times said on Monday (2nd):

What is more certain is that its latest move has not done anything to enhance its credibility as a central bank. Rather the feeling is of a slightly panicky monetary authority that is not quite sure how to handle the situation; a view that is bolstered by its conflicting signals on the exchange front.

A day after the bank seemed to have decided to limit its intervention in the forex market, allowing the rupee to appreciate to an eight-year high, it was back in strength. The rupee promptly lost 70 paise in a day. Not all Germans believe in God, but they all believe in the Bundesbank, said former European Commission President Jacques Delors. After the latest move, it will be a some time before we say anything similar about the RBI.

To think effectively about the situation, it is important to think that RBI is a set of high IQ people with considerable competence. Let's be neoclassicals and always attribute intelligence and drive. So it behooves us to ask: What are they maximising?

Central banks are not autonomous creatures that run monetary policy based on their own views. They are agents of Parliament. The RBI Act of 1934 is the contract under which Parliament has outsourced the task of doing monetary policy to RBI. RBI is the agent, and Parliament is the principal. In this setting, much insight is obtained by thinking about the principal-agent problems. What are the agency conflicts of the present contractual structure? How can these agency conflicts be eliminated?

As of today, this contract is poorly drafted. If you ask RBI "Why did you not contain inflation?", it can give you numerous plausible replies. He can say it was because you burdened him with bond issuance for the government (low interest rates were required to subsidise bond issuance), or banking regulation (low interest rates were required to protect banks), or currency objectives (low interest rates were required to deter capital flows).

If RBI's conduct is confusing, it's because the outsourcing contract is poorly drafted. It leaves RBI with tremendous leeway to exercise its own discretion on choosing what monetary policy ought to do, and it leads to a loss of accountability - when you are expected to do two things, you are free to do neither because you always have an excuse.

Hence, I have repeatedly argued that the need of the hour is a redrafting of the outsourcing agreement, to achieve a simple framework where there is complete clarity on what RBI has to do. This redrafting of the RBI Act needs to bring in a framework of transparency, accountability, independence and focus. Better contracting between government and entities outside government is being done in many fields - e.g. CEOs of PSU banks will get bonuses when they do well. RBI will change its behaviour when the governor gets a bonus based on how well he achieves an inflation target.

It is fashionable to criticise RBI these days. The real problem lies not with RBI but with Parliament and the Ministry of Finance. The Ministry of Finance has not woken up to the dangers of running monetary policy in the India of 2007 based on a 1934 outsourcing contract that is ultimately animated by policy thinking over 1913-1926.

Update (6/4): Jamal Mecklai has a great piece in Business Standard on the subject of RBI reforms and the monetary policy regime. And (10/4), Suman Bery summarises recent discussions and suggests that greater exchange rate flexibility is the key. Update (11/4): an editorial on these debates in Mint.

Mumbai as an International Financial Centre (MIFC)

The report of the High Powered Expert Committee (HPEC) on Mumbai as an International Financial Centre (MIFC) has been released. The report itself has been published by Sage Publications. The website of the Ministry of Finance has:

• A web page with the full report and a collection of materials on the subject.
• Video files from a CII conference on the subject. In particular, the talks by P. Chidambaram, Vijay Kelkar and Brooks Entwistle are well worth watching. Warning: They are .wmv files and don't work on all machines. And, for the wmv-challenged or bandwidth-constrained, MOF has a PDF file with a transcript of FM's talk.

Percy Mistry, who was the Chairman of the committee for most of its life, has written an article: The Mumbai-IFC report: of Discourse, Garlands and Brickbats!. A fascinating stream of commentary has started coming out from 4 April onwards:

• Editorials in Financial Express, Business Standard, Economic Times, Indian Express, Mint. An editorial in The Telegraph asks `Why not Calcutta?'. Economic Times.
• Gautam Chikermane in Indian Express.
• Shaji Vikraman in Economic Times.
• Andy Mukherjee on Bloomberg.
• High finance for the aam admi, T. K. Arun, in Economic Times.
• Rajrishi Singhal in Economic Times.
• A fine theme for a dream, by Mythili Bhusnurmath, in Economic Times.
• A. V. Rajwade in Business Standard.
• Richard Lambert compares the MIFC report against London's story, in Financial Times ($$).
• Deepak Lal in Business Standard.
• Nitin Desai in Business Standard.
• An editorial in Financial Express and another in Business Standard.
• The end of cynicism, by Jamal Mecklai in Business Standard.
• The Mystery Of Missing Mistry, by Ashok V. Desai in Business World.
• An interview with Percy by Sitanshu Swain and Umesh Kumar in Financial Express.
• Bombay Plan 2007, by Vijay Kelkar, in Indian Express. (This is based on the video file by him that's mentioned at the start of this blog entry).
• Mumbai as a global financial centre, by T. Thomas, in Business Standard.
• Mumbai's Moment, and an interview with Percy, by Mobis Philipose and M. Anand in Business World.
• Talk by M. Narasimham on MIFC at ASCI, Hyderabad.
• An interview with Percy in DNA.
• Maximum city? by Sanjeev Sanyal in Indian Express.
• Mumbai IFC: A visionary report, by S. S. Tarapore.
• Mumbai as IFC, by A. V. Rajwade.
• Should finance ministry start handling public debt?, by K. G. Narendranath and M. K. Venu.
• India's shackles, by Stewart Fleming in Financial World.
• Evaluating Mumbai's IFC aspiration by U. R. Bhat in Economic Times.
• The mystery report, by Shankar Acharya in Economic Times.
• Cracking open India's capital account, by Eswar Prasad, in Asian Wall Street Journal.
• Currency derivatives, an edit in Financial Express.
• Win-win in India by Stewart Fleming in Financial World.
• Article on MIFC by Sanjeev Sanyal of Deutsche Bank.
• Finance tail wagging the economy dog, by T T Ram Mohan, in Economic and Political Weekly.
• Ahmedabad instead of Bombay?
• I wrote an article on the implications of MIFC for the domestic securities industry.
• Booming Mumbai floods, lacking political will, by John Elliott.
• Finance and India's development, by Nirvikar Singh, in Financial Express.
• Article by Jaimini Bhagwati in Business Standard.
• Article by S. Venkitaramanan in Hindu Business Line.
• Article by Vinayak Chaterjee in Business Standard.
• A blog entry by Saravade.
• Several birds with one stone, in Business Standard, by Jamal Mecklai.
• Article by Rajeev Malik in Economic Times.
• Article by Jaideep Mishra in Economic Times.
• Icing on the cake by Subir Gokarn in Business Standard.
• Waterfront Suffers Neglect as Mumbai Rents Zoom by Andy Mukherjee on Bloomberg.
• Article on the political economy of the MIFC report by Ila Patnaik in Financial Express.
• RBI: Don't hurry convertibility, by Surabhi, Financial Express.
• Article by Nirvikar Singh in Financial Express.
• Implications of new international financial centres, in Business Standard, by me.

And here are some recent developments which link up to the picture of MIFC, though they are not directly linked to the book:

• A New York Times story on global banks taking interest in Bombay.
• An article in Economic Times by Bodhistava Ganguli about financial services exports that India could do on the strength of having no estate tax.
• Bombay's growth gets Shanghaied, by Salil Tripathi in Far Eastern Economic Review, April 2007 [pdf].
• Mumbai amongst world's top 10 financial hubs, in Indian Express, 18 June 2007. Also see the blog entry by Jayanth Varma on interpreting this.
• Should RBI or SEBI regulate the currency futures market? An edit in Business Standard.
• Korea makes the moves towards IFC.
• The race is on to be Asia's #1 for finance, by Sundeep Tucker, Financial Times.
• Come one, come all, by Edward Glaeser, New York Sun.
• Lessons from Motown, by Daniel Gross, Newsweek.
• Maharashtra vs. Gujarat as financial centres.

Lots of people are asking me: From what store do I get the book? I just got this information from Sage about Bombay and Delhi. In Delhi: Teksons at Noida, Greater Kailash, Part I, South Extension, Part I, Saket. Midlands at Aurobindo Market, South Extension, Part I. Bahrisons at Khan Market. New Book Depot at Connaught Place. Some other bookshops in Khan Market seem to have it too. In Bombay: Crossword (all locations), Strand Bookstore, Horizon at Vile Parle (W), Granth Book Shop at Juhu and Goregaon (W), Landmark in Andheri (W). In Washington, D.C.. On Amazon.
Slideshows about MIFC: by Percy Mistry, K. P. Krishnan, Josh Felman, me.
If you would like to link to this page, http://tinyurl.com/mistry is a handy shortform for the full URL - http://ajayshahblog.blogspot.com/2007/04/mumbai-as-international-financial.html

Forcing private firms to not buy wheat

The media has been hot on the trail of stories of the government forcing firms like ITC to not buy wheat in Punjab and Haryana: IE, ET, TOI, Monsters and critics, India PR Wire. Update (13/4): it seems to have worked; the government seems to have pretty much bought all the wheat from Punjab and Haryana.

Business Standard has an edit on this problem:

The large corporations who are participants in the wheat trade have been informally requested by the Central government to not buy wheat from Punjab and Haryana. The context is that last year, firms like Cargill and ITC had bought up roughly 1.3 million tonnes, or 17 per cent, of Punjabs wheat output, by paying Rs 20 per quintal more than the price offered by the government. The legitimacy of the governments request is suspect, and various industries (cement, steel) have demonstrated in recent weeks that they are not about to panic because the government frowns on their pricing or other decisions. Everyone knows that the government has the power to order tight stocking limits for essential commoditiesthus forcing wheat supplies into the market. Still, can and (perhaps more important) should the government come in the way of a private transaction between two citizens of India?

There is a potential shortage of wheat, and the government wants the private sector to step aside. However, the supply/demand situation in the country is not altered by shifting wheat from private to public hands. When thinking about Indian food security, what matters is the supply of wheat in India not the control of wheat in the hands of the government. The private sector does a better job of cost control and the use of technology in purchase, ransportation and storage. By elbowing out the private sector, and forcing this industry to be a government monopoly, the cost suffered by India goes up. The government has a long history of allowing wheat to spoil in storage. The private sector does a better job of taking care of wheat in warehouses. If more wheat is lost in storage, the country loses.

The firms concerned will continue to be in a business which requires wheat as raw material. Their buying pressure will be greater in Rajasthan. This will excite many people to buy wheat in Punjab and Haryana, transport it to Rajasthan, and sell to these corporations. Once again, this is inefficient for India because of the transportation and labour costs, which are layered on top. In addition, it would tend to frustrate the goal of the government, of having an exclusive right to buy all wheat in Punjab and Haryana. Also, these developments adversely affect the interests of farmers in Punjab and Haryana. The best situation for a farmer is to have multiple buyers vying for his output. By knocking the large private corporations out of the picture, the government has reduced demand for wheat and thus hurt the income realisation of farmers.

This governments action reflects one more piece of a jittery and intellectually confused response to inflation. The government is right in worrying about inflation, as the rise in inflation over the past year has been about 3 percentage points, and the gap between macro-economic supply and demand needs to be addressed. The primary tool for this ought to be monetary policy. If the RBI focuses on this, the country could avoid the slew of distortionary government interventions in the real economy ranging from banning exports of milk powder to banning futures trading to instructing private corporations to not buy wheat in Punjab and Haryana.