Set up a rolling fund for trading in forex and to stabilize rupee

22 August, 2012

Industry body Assocham has demanded that The Reserve Bank of India (RBI) should consider setting up a rolling fund for trading in foreign exchange and alternatively allow the Indian firms to issue dollar-denominated shares to prevent wild swings in rupee and break its nexus from the FII inflows or outflows.

THE INDUSTRY body's study, ‘Financial sector instability following global crises’ found a strong co-relation between FII outflows and the movement of the rupee exchange rate. This is emerging to be the immediate cause of the increasing frequency of oscillation in the exchange rate.

It said whenever an economic crisis hits the rupee and the rate depreciates, it remains at the lower level rather than come back to the pre-crisis level. The next crisis pushes the rate to another low. Thus there is a “ratchet effect”. There has been a partial exception only after the 2008 crisis when the rupee had partly recovered lost position.

For averting this situation, the study recommends that “the Reserve Bank of India should have a small rolling fund earmarked for trading in foreign exchange, synchronized with the entry and exit of the foreign institutional investors (FIIs). RBI should buy dollar or other hard currencies from the market when FIIs are coming in and sell when they are exiting. This should cushion the rupee, it said.

Alternatively, a specific market for FIIs where dollar denominated script of Indian companies could be traded, can be considered. “To the extent FII holding is allowed in Indian companies, we allow Indian companies to issue dollar denominated shares. These will of course have some equivalence with the prices of the same shares in the stock markets through the prevailing exchange rate”.

The study said such a system will obviate the need for FIIs to convert their investible funds into rupee every time they want to invest and reconvert every time they want to exit. ” Such an alternative exchange could become an offshore trading bourse and help India emerge as an international financial centre”.

Over the last one year, the rupee value has depreciated by almost 25 per cent having a severe adverse impact on the Indian economy, which is driven significantly by imports.

FIIs by nature contribute to foreign exchange inflow for the host country. They help in supplementing the domestic savings and investments. The FII investments into the equity markets also help in the rise of the stock markets.

However there is a flip side attached to this as well. Given the huge volume of investments made by these foreign institutional investors there is a high possibility of them creating an asset bubble of sorts.

India’s experience with FII investments shows that the investments have grown from Rs. 45 881 crore in 2004-05 to Rs. 93,726 crore in 2011-12.