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June 1, 2000

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Devangshu Datta

Will RBI print more notes?

For many, the very mention of the Simex (Singapore Monetary Exchange) triggers unforgettable memories of 8888. In traditional Chinese numerology, this is the equivalent of death four times over. Nobody in the history of the Simex had ever dared ask for that trading account number. Until, that is, an English upstart called Nick Leeson arrived on the scene to fulfill the dual functions of chief trader and back office accountant for the venerable British Bank of Barings.

Leeson had no truck with Chinese superstitions. Barings had opened that account more or less by accident, and never used it. When one of Leeson's traders made a mistrade, he struck upon the bright idea of squirreling away the evidence in "four eights", until he could set it right. Since his head office didn't know about the existence of that account, there would be no comebacks. It worked once, it even worked a second time. He made counter-trades, darned the holes in his books and carried on.

Then Leeson pulled a Texas hedge. He believed, wrongly as it turned out, that the yen would depreciate against the dollar. From there, to believing that the Nikkei would jump on higher exports if the yen fell was but a matter of a moment. So, sell the yen and buy the Nikkei. A small matter of some $ 800 million worth of losing futures contracts later, the oldest investment bank in the world was a smoking carcass. That money had all flowed through 8888.

Well, that's all in the past. Leeson has served his time and the Simex is gone. Its successor, the SGX-DT (Singapore Exchange Derivatives Trading) is bigger, it trades more contracts and it flies higher. It affords seamless connection to the CBOT (Chicago Board of Trade), which is the biggest derivative trading exchange in the world.

The SGX-DT is the biggest exchange to trade Japanese futures. It also allows registered players to play the entire range of the CBOT. Sometime this year, the SGX-DT will start trading the S&P CNX Nifty. The National Stock Exchange (NSE) will be paid 10 cents per contract for farming out the 50-stock Indian benchmark index. First, of course, the NSE has to start trading in Nifty futures itself. There is a proposed two-month lag between the NSE launch and the SGX-DT launch.

This move, specifically the farming out of the index offshore has both positive and negative aspects. As to the advisability of trading Nifty futures itself, that is a no-brainer. It will allow, both, speculators and hedgers to move off the spot market and streamline the ALBM (Automatic Lending and Borrowing Mechanism), which is far more open to abuse. The current market mechanisms mix spot and futures trading either through the realm of badla or via ALBM. The concept of naked short-sellers and bulls, who carry over long positions eternally (on the Bombay Stock Exchange), will gradually evolve into clearly separated spot and futures markets.

The greater clarity of risk-reward equations on a futures contract is always preferable to badla-style mechanisms. In any derivative contract, the key elements are the time-frame, the cost of carrying in terms of market interest, and the value and volatility of underlying assets. When it comes to complex derivatives with several linked underlying assets and non-symmetric risks and obligations, pricing correctly is a problem. When it comes to a deliverable underlying asset, there can be default.

But the Nifty is by definition, a non-deliverable asset. It is also a non-complex derivative - there is only one underlying asset, and the risks are symmetrical to long and short players. So, a Nifty futures trader knows from purchase to expiry what his exact risks and rewards are. The greater leverage will tempt speculators and hedgers to migrate to the futures market. This will ease the risk of default in Nifty stocks themselves.

But there are some interesting problems in trading futures offshore. The primary question is managing the forex risk. Will it be the Defty or the Nifty that is actually traded? There is a significant difference, which cannot be properly hedged in a non-convertible currency.

The rupee is likely to retain its current status of managed partial convertibility. After all, it was stated in the 1993 Budget that the rupee would move towards full convertibility. That was when current account transactions were freed. Since then, a lot of reasons, some of them perfectly valid, have been advanced to prevent the final transition to a free capital account.

If the Nifty is traded abroad, the SGX-DT trader swallows the exchange risk, since payments there will be hard currency denominated, while the price of the Nifty will swing without taking that into account. If the Defty is traded abroad and on the NSE, the domestic investor is forced into exchange risks, which cannot be hedged.

If the Nifty is traded here and the Defty abroad, foreign arbitrageurs have a field day with every rupee-dollar fluctuation. This market imperfection cannot be easily removed without full convertibility and that would be like killing mosquitoes with howitzers. How about if both products are on offer here and abroad? Then we could have a shadow market for hedging currency risks without actually putting pressure on the rupee. That would be the ideal situation.

Another interesting question relates to impact on foreign institutional investors (FII) inflows. It is true that FII trades are delivery-based. But the very existence of an offshore hedging mechanism with high leverage may pull India allocations away to the SGX-DT. In which case, forex inflows will ease up.

This is a year when the existence of forex inflows is of extreme importance for domestic money supply. The Reserve Bank of India (RBI) has to pull about Rs 1.18 trillion out of the hat. That works out to around Rs 45 billion per fortnight. There have been massive devolvements in the last two auctions and the central bank will have to raise cut-off yields to get money from the market.

That has upward implications for interest rates, but let us assume that the RBI will get its money, one way or another. However, if the RBI has to maintain money supply while raising Rs 45 billion per fortnight, it will be forced into simultaneous forex sterilisation. It must buy approximately $ 1 billion worth to release rupee equivalents of Rs 45 billion and maintain money supply.

If the forex inflow isn't there, pressure on money supply is inevitable. On India's track record, it would be optimistic to assume $ 26 billion worth of annual inflows anyway. If the SGX-DT does pull significant inflows, the RBI may be reduced to printing notes. Otherwise, it would have to cut credit reserve ratio to the bone to maintain money supply if it is unwilling to monetise or sterilise. That would be a fascinating exercise with ramifications well outside our current scope.

Devangshu Datta

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