In defence of Reserve Bank measures

Our foreign exchange markets have a dichotomous structure. Out of the nearly 110 authorised dealers, you have the State Bank of India and a dozen active banks (foreign and new private-sector banks) that actually lead the market on one side, and about 90-and-odd authorised dealers (banks with foreign-exchange licences) who are led by the former, on the other side. The first group makes the market, while the second ‘participates’ in the market.

Thirty-five per cent of the underlying merchant flows are with the first group and the rest with the second group. Even within the first group, State Bank alone would account for over 25 per cent of the merchant flows. Profile-wise, State Bank would probably fit better with the second group, but by the sheer market size (a factor which is gradually diminishing over the years) it commands respect in the market.

The aggregate overnight limits of all these dealers would be around Rs 1,000 crore on a very conservative estimate. This roughly equals $250 million. While the overnight limits have been approved for each bank by Reserve Bank of India taking into account factors like the bank’s net worth, its share of foreign exchange business and ability to manage risks, the intra-day open positions are completely left for the banks to decide.

Consider this: the first group of banks (probably excluding SBI) is the least amenable to ‘moral suasion’. Of the $250-million overnight limit, as much as about $100 million will be with the first group of banks. These banks have the potential to sell rupees to the equivalent $500 million if one assumes a multiplier of five during the day. This could well push the rupee down (by taking which view their managements may not fault them).

But one can see the harmful impact such operations will have on the market and on the value of rupee. Not only could these banks trigger panic and collapse, but also they have no ability to control the subsequent course of events.

One may argue that at the end of the day, they have to revert to the prescribed ceiling. But, before that they would have wrought havoc. One may also argue that their end-of-the-day unwinding operations should lead to precisely the opposite reaction (upward movement) in the value of rupee. But, in all probability, their spot sales will be covered by forward purchases which will square their open positions and at best drive down the forward premiums which have a natural barrier (at shorter maturity ends) by way of the interest-rate differentials between the rupee and the dollar.

Also, so long as the parent banks’ dollar funding support is available to these banks, they would run open positions — of course, within the overall limits accorded to them. Does this mean that what has been achieved over the Rangarajan era should be unwound? No. But the south-east Asian experience has shown the ruthless manner in which economies are put back by years by international operations. Under the circumstances, RBI could:

Already, the restrictions on nostro balances has led to a phenomenal rise in forward premiums in the near forwards. This rise is exerting an upward pressure on short-term rupee interest rates. There is thus a strong case to exclude nostro balances from the purview of overnight investment restrictions to ease pressure. Sustained export growth has been the cornerstone on which the reforms are based. The reality is that exports have floundered after two years of growth. Unless we broaden the base of the sectors driving economic growth, we would be vulnerable to attacks as seen in south-east Asia.

(The author is the executive vice president (Treasury & Forex) of ICICI Banking Corporation)