“Why even an NDF Dog cannot wag the on-shore tail, much less an NDF tail wagging the on- shore Dog !”

By VK Sharma,

Former Executive Director, 

Reserve Bank of India                                       

       There is quite some compulsive feel, rather than any grounding in logic and reason, to the current hype and hoopla over Non -Deliverable Forward (NDF) market influencing the on-shore USD-INR market ! And,no less, a high degree of interlinkage / correlation between the two is confused with causality. This is because the whole debate lacks in conceptual clarity on how arbitrage actually happens both, in theory, and practice. Only through the organic connect of arbitrage is it possible for information in one market to be seamlessly transmitted to, and influence,the other market. Arbitrage between discrepant prices of an asset in two different markets requires taking simultaneous long and short positions to benefit from, and eventually align, the discrepant prices in two markets. Tautologically, this arbitrage is risk free in that loss on one position is offset by a matching gain on the other and vice versa .  But restrictions on who, and how one, can take positions in the on-shore and NDF USD-INR market come in the way of agents engaging in risk-free arbitrage for NDF market to influence exchange rate in the on-shore market. More specifically, domestic entities, whether banks or businesses / individuals, are not permitted to engage in any transactions in NDF market. But banks are permitted to take open positions in the on-shore OTC (Over the counter) forward market subject to RBI monitored, and supervised, limits and businesses/ individuals are permitted to engage in on-shore OTC forward market subject strictly to actual underlying - exposure requirement and not otherwise . In other words, a forward seller (exporter) has to have actual underlying export and a forward buyer (importer/ foreign currency borrower) has to have actual underlying import/ foreign currency loan. Therefore, if FEMA regulations are not breached / violated, arbitrage between the two markets is impossible because the net position will always be open and not zero which is the hallmark of any arbitrage. Specifically, if forward dollar is trading higher in the NDF market relative to the one in the on-shore forward market, an arbitrageur will typically sell the dollar forward in the NDF market and buy it forward in the on-shore market. But a domestic entity cannot do this because of FEMA regulations which require an actual underlying exposure i.e. either an import order or foreign currency loan. And if there indeed is such an actual underlying exposure, then the net position is not zero- a ' sine qua non ' for a typical arbitrage - but actually net short because the actual underlying short position of import/ foreign currency loan is offset by the on-shore long forward dollar position, leaving the NDF short dollar position open and thus exposing the entity to the risk that the US dollar may appreciate which may potentially more than wipe out the entire arbitrage profit ! Of course, if only there is no underlying actual exposure in the way of import, or foreign currency loan, will a typical arbitrage be possible with the on-shore long forward dollar position exactly offsetting the NDF short forward dollar position, locking in the benefit of higher NDF forward dollar price ! But this will not be possible if FEMA regulations are strictly monitored and actually enforced . In other words,  only in breach and violation alone of FEMA regulations will the much-hyped arbitrage be possible and in no other way ! The same holds when the opposite is the case viz; the forward dollar price is higher in the domestic on-shore market relative to the one in the NDF market in which case an arbitrageur will typically sell dollar forward in the domestic on-shore market and buy dollar forward in the NDF market. But, again, a domestic entity cannot do this because of FEMA regulations which require an actual underlying exposure i.e. export order. And, therefore, as before, if there indeed is such an actual underlying exposure then the net position is not zero - a ' sine qua non ' for a typical arbitrage - but actually net long because the actual long position of export is offset by the on-shore short forward position, leaving the NDF long dollar position open and thus exposing the entity to the risk that the US dollar may depreciate which, as stated before, may potentially more than wipe out the entire arbitrage profit ! Of course, if only there is no actual underlying exposure in the way of export will a typical arbitrage be possible with the on-shore short forward dollar position exactly offsetting the NDF long forwarddollar position, locking in the benefit of higher onshore forward dollar price ! But again, as before, this will not be possible if FEMA regulations are strictly monitored and actually enforced. In other words, again , as before, only in breach and violation alone of FEMA regulations will the much - hyped arbitrage be possible and in no other way ! The foregoing thus conclusively proves and establishes that the NDF USD INR market influencing the on-shore USD INR market cannot just happen, except ,of course, only in breach and violation of FEMA regulations, and to that extent, RBI and Government must agonize only over effectively,decisively, credibly and inviolably enforcing extant FEMA regulations ! 

While still on the subject, as regards statistically establishing causality, this can be credibly and effectively done by recourse to the so-called Granger Causality Test. But it is very important that the USD-INR data points must be taken as frequently as feasible for the Granger causality conclusions to be robust and reliable. Ideally, such data points can be taken at 5 to 1 minute intervals when both the markets are active . Since  NDF market is almost a 24- hour market, the data points can easilyoverlap the market timings of the on-shore market. Significantly, under no circumstances should  Granger Causality Test   be applied to closing data points !