The Indian rupee (INR) slumped to a record low of 59.98 against the US dollar on June 20 throwing a fresh challenge to the authorities to revive the flagging economy. The local currency tanked more than 9 percent since the beginning of May.
Reason: Overseas investors are exiting their emerging market investments including from India. Federal Reserve chairman Ben Bernanke has hinted at cutting liquidity easing stimulus on the back of improvement in the US economy. The US treasury bond prices are falling (or, yields are rising). Investors are withdrawing money from other countries to park it back in US.
Non-deliverable forward (NDF) play...
That is not all but only the main factor. At the same time, some large institutions swing into action to make some quick bucks using the prevailing negative sentiment. Here comes the play of non-deliverable forward market. This can happen with any pair of currencies viz. USD-INR, USD-GBP, USD-Euro, Euro-INR and so on.
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Last week, INR dropped 3 percent against the greenback. Amidst the freefalling on the back of weak economic parameters, some investors also took the advantage of arbitrage between NDF and domestic markets. They were buying dollars at below 59.90/USD level and selling in the overseas market. The three-month NDF was quoting around 60.80-60.90/USD, three currency traders told moneycontrol.com.
"NDF factor is not the prime reason behind the rupee depreciation but adding to the woes," said a senior currency expert from a bank. He did not wish to be named.
"Due to NDF arbitrage, we are suffering. No bank is allowed in NDF unless its registered office is outside India. Mostly big corporate institutions are seen earning quick money using this tool. They place orders through foreign banks. However, they will not do it below 15-20 paisa margin," he said.
NDF arbitrage and its practitioners
An oil and gas major and some big diamond merchants are engaged in this arbitrage practice, said traders adding that it is not illegal. NDF arbitrage practice is nothing new.
However, many-a-times it increases market volatility when accomplished with higher degree. RBI intervenes to check any high volatility.
There are generally three types of parties: banks which trade with genuine requirements, institutions having legal access both in domestic as well as NDF market and NDF punters, who does not have direct access to India currency market.
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The origin of NDF punters is a bit suspicious and not widely tracked. Sensing the market sentiment, they take position in the NDF market. This in turn, helps raising or decline the exchange rate. Back home, some institutions consequently, find widening difference between NDF and domestic forward market. They immediately act.
However, on maturity of forward contract, investors need to make the delivery by buying/selling from domestic spot market. This impacts the spot exchange rate.
What is NDF market?
It is an offshore currency forward market wherein delivery of contracts does not take place on maturity. Hence, the term is “non-deliverable”. For example, an investor books a three-month USD-Rupee contract at 62. Suppose, rupee moves to 63 against the USD after three months. Then, s/he has to buy dollar similar to contract size by selling rupee to close the contract on maturity.
However, in NDF market, one will not do the same but only settle it with the difference amount, be it profit or loss. In the illustration mentioned above, it will be a profit (63-620 = 1).
Need for NDF
Indian rupee is fully convertible on current account while it is only partially convertible on capital account. This justifies the need of NDF market. In simple, term, capital account denotes long term money like foreign direct investment (FDI). Current account is short-term in nature.