With the new Pakistani Rupee v/s US dollar contract, will history repeat itself?

With globalization blurring boundaries, the constant and ever-increasing exposure of Governments and corporates to foreign currencies have placed them at high risk. Especially, currencies like the Indian Rupee or the Pakistani Rupee which are not fully convertible, which means that these cannot be easily converted into gold or another currency through global exchanges, are feeling the heat more than others. However, if through some efforts, the rupee is made fully convertible, it would result in increased liquidity in the financial markets, improved employment new business opportunities, and easy access to capital.

Back in 2007, the DGCX – Dubai Gold & Commodities Exchange - launched the trading of US dollar-based future contract for Indian Rupee vs. the US Dollar, writing a new chapter in the economic history of emerging countries. Following the trend and knowing the fact that Pakistan nationals are the second largest expatriate population living in UAE, DGCX has recently announced the launch of trading of US dollar-based future contract for Pakistani Rupee vs the US Dollar starting on 16th April 2021. But was the previous future contract with the Indian Rupee actually beneficial? If yes, what are the chances of history repeating itself with the Pakistani Rupee?

I am not an economist by profession but over the years, I have been a keen observer and aficionado of foreign currencies. During my recent interview with Mr. Kamran Ahmed Riaz, a Pakistani national and businessman based out of the UAE, we discovered that this move is going to be beneficial for everyone whom either deals with or has invested in the Pakistani Rupee. However, once we concluded, he asked me a question that made me recollect some facts from the past which probed me to write this blog.

 https://www.dhirubhai.net/posts/pankajgupta08_dgcx-pkrfutures-pkrrupee-activity-6782593277376950272-GNXc/

The question Mr. Kamran raised was “How is the future contract of Pakistani Rupee vs US Dollar going to benefit Pakistan?”

His question took me by awe for how concerned he was about the country he belonged to and the possible economical repercussions of such a move. So this is for Kamran and all my Pakistani friends and investors.

 Global macro-economic events like the 2008 financial crisis and the pandemic of 2020 have time and again highlighted the importance of providing a wide range of hedging options for entities. This provides some stability to emerging market currencies especially during the flight of capital to safeguard the ‘global risk off’ sentiment. Pakistan will be the latest addition to the same. Pakistan’s currency is all set to initiate trading on DGCX. 

Now let’s take a step back into the past and see what really happened when the Indian Rupee contract was launched at DGCX. As expected, there were several concerns surrounding the introduction of currency futures trading on global exchanges. One of the major concerns was would futures trading on global exchange increase volatility? Another concern was that global participation could be much higher leading to higher volumes. This could have eventually lead to increased speculative activity and would keep things out of RBI’s control. However, research has shown that there is no clear evidence to suggest that currency futures result in enhancement of volatility in the spot exchange market. 

However, empirical evidence is inconclusive as to whether currency futures add to higher speculation in a currency than is possible without them. While theoretically, it is believed that futures markets largely operate on a premise similar to that of forwarding markets – reflecting interest rate differentials. However, studies show that in India, as in the case of many other countries, forward prices largely reflect not just interest rate differentials, but currency markets are susceptible to influence positive or negative sentiments depending on the economic inflow of data too.

The benefits of listing currencies at foreign exchanges are twofold – to expand trading opportunities for market participants into the market of the currency, reduce price volatility on account of increased options to trade, and at various time zones. Some of the disadvantages include higher volatility, an increased burden of foreign debt, and an effect on the balance of trade and exports.

In India’s case, I feel that listing currency futures on a global exchange has helped Indian Exports, Foreign investments into Indian Equity/Debt markets, and Foreign Direct Investments. The entire credit, however, cannot be given to the launch of the future contract of Indian Rupee vs US Dollar but it would have potentially influenced the same by giving enough confidence to foreign investors to hedge their risk while investing in various schemes and policies designed by the Indian Government to attract foreign investors. 

Hedging the risk using futures contracts allows exporters to efficiently manage credit risk, especially during extraordinary situations as Indian Forex futures markets trade for a limited time only while global currency markets trade for a lot longer hours. Since Forex markets have a high turnover and allow participation by participants from across the globe without any restrictions, it allows larger volume transactions to go through seamlessly without distorting levels and with low or no impact cost.

Given the fact that India’s exports growth has been consistently above 20% since 2007, when the Indian Rupee was listed on the DGCX, thanks to a combination of global macro and trade-related factors, it cannot be denied that DGCX listing has definitely allowed Indian and global traders to efficiently hedge their foreign currency exposure. 

Source - https://www.macrotrends.net/countries/IND/india/exports

 With the increase of additional hedging alternatives, FII (Foreign Institutional Investors) inflows into the Indian capital markets have had a positive impact for sure. While FII flows are largely dependent on factors like alpha-generating potential, conducive policy environment, and investor-friendly tax regime, the ability of the investor to freely move in and move out of the emerging capital markets with the least possible damage on the forex front also plays an important role. During the ‘risk off’ sentiment, unwinding of carrying trade takes place, and given the rush to safe havens, a smooth unwinding of currency positions gives confidence for the investors to increase exposure to emerging markets like India. This was visible over the last ten years as can be seen in the exhibit.

Source: NSDL

 While FIIs are very volatile due to a short-term horizon, FDIs (Foreign Direct Investments) have much more bearing on a country’s macroeconomic landscape. Listing of currency futures on foreign exchanges would give much-needed confidence to foreign investors. With the latest relaxation of FDI norms in the insurance sector and given the current Government’s focus on asset monetization and making India more investor-friendly, we expect to see increased FDI flows into India in coming years. According to a survey by CII-EY, India is expected to attract FDI investments of $120-160 Billion by 2025.

  Source: RBI

 Currency Future contracts, however, need to be dealt with caution. We as entrepreneurs have to be cautious and understand that while hedging is used to help manage currency and global business risks, corporates should be well aware of the risks involved in it and the discipline it requires. There are many instances where the corporate treasury boards have put the survival of their company at risk of being lured by the temptation of profits of Forex trading. It is important to understand the scope and limitations of Forex hedging so that management expectations are realistic and feasible. 

For those who don’t have a financial background, the above may seem overwhelming. But in conclusion, here’s the answer to my friend Kamran.

While considering all the angles involved in any country’s economy and provided that the Government and the people of the nation are progressive, this can help attract FDIs to uplift the bottom line of any economy.

I am looking forward to seeing history repeat itself, maybe at the DGCX or in the economic data of Pakistan in years to come.