By Advocate Rapolu Bhaskar | November 1, 2024
The recent growth of the offshore non-deliverable forward (NDF) market in the Indian rupee (INR) has posed significant challenges for the Reserve Bank of India (RBI) in its efforts to maintain exchange rate stability. This article explores the factors driving the growth of the offshore NDF market, the implications for domestic financial markets, and the RBI’s proposed regulatory measures aimed at exerting influence over this sector.
The Challenge of Exchange Rate Stability
Maintaining a stable exchange rate has long been a priority for the RBI. Since officially adopting a market-determined exchange rate system in 1993, the RBI has actively intervened in the foreign exchange (FX) market to curb excessive volatility. However, the rise of the INR-NDF market—now the second-largest NDF market globally—has complicated these efforts. The offshore NDF market, which allows participants to speculate on currency movements without the need for physical currency exchange, operates outside the RBI’s jurisdiction, thereby limiting its control.
Emergence of the INR-NDF Market
The INR-NDF market has flourished due to capital controls and a complex regulatory environment in India. Despite the presence of an onshore INR forward market, foreign participants often face barriers that drive them to the offshore market in locations such as Singapore, London, and New York. Here, they can hedge currency risks associated with the rupee without the stringent capital-account restrictions imposed by the Indian government.
The Bank for International Settlements reported that the volume of NDF contracts for the USD-INR pair surged from $16.4 billion in 2016 to $50 billion in 2019. This growth has raised concerns about the offshore market’s influence on the onshore exchange rate, especially during periods of economic uncertainty.
RBI’s Regulatory Response
In response to the challenges posed by the offshore NDF market, the RBI has proposed a draft regulation allowing offshore electronic trading platforms (ETPs) to register with the Central Bank. This move aims to establish a level of regulatory oversight and potentially give the RBI extraterritorial reach over the offshore market. The RBI’s efforts reflect a growing recognition of the need for increased transparency and regulation in the OTC derivatives market following global financial crises.
The new framework for offshore ETPs is intended to facilitate Indian banks’ participation in the NDF market, which has been limited due to the absence of clear regulations. The RBI’s initiative is seen as an attempt to align the interests of offshore ETP operators with its objective of maintaining exchange rate stability.
Legal Implications and Potential Impact
The extraterritorial nature of the RBI’s proposed regulations raises important legal considerations. The RBI Act of 1934 empowers the RBI to regulate financial markets in the public interest, and legal precedent suggests that it may have the authority to govern actions impacting Indian markets, even if they occur offshore.
The successful implementation of these regulations could lead to increased participation by Indian banks in the NDF market, thereby enhancing the RBI’s ability to influence exchange rates. However, the RBI must ensure that its approach remains consistent and predictable to foster trust and encourage banks to engage in the offshore market.
Conclusion
The development of the offshore INR-NDF market has posed significant challenges for the RBI’s management of the rupee. By proposing regulations for offshore ETPs, the RBI aims to regain some control over the NDF market and align the interests of domestic and international participants. Should this strategy succeed, it may set a precedent for other emerging market central banks facing similar challenges. Ultimately, proactive measures to liberalize onshore currency derivative markets may be necessary for long-term stability.