Introduction

During 2003-04 the average monthly turnover in the Indian foreign

exchange market touched about 175 billion US dollars. Compare this with
the monthly trading volume of about 120 billion US dollars for all cash,
derivatives and debt instruments put together in the country, and the
sheer size of the foreign exchange market becomes evident. Since then, the
foreign exchange market activity has more than doubled with the average
monthly turnover reaching 359 billion USD in 2005-2006, over ten times
the daily turnover of the Bombay Stock Exchange. As in the rest of the
world, in India too, foreign exchange constitutes the largest financial
market by far.

Liberalization has radically changed India’s foreign exchange sector.

Indeed the liberalization process itself was sparked by a severe Balance of
Payments and foreign exchange crisis. Since 1991, the rigid, four-decade old,
fixed exchange rate system replete with severe import and foreign
exchange controls and a thriving black market is being replaced with a less
regulated, “market driven” arrangement. While the rupee is still far from
being “fully floating” (many studies indicate that the effective pegging is no
less marked after the reforms than before), the nature of intervention and
range of independence tolerated have both undergone significant changes.
With an over- abundance of foreign exchange reserves, imports are no
longer viewed with fear and scepticism. The Reserve Bank of India and its
allies now intervene occasionally in the foreign exchange markets not
always to support the rupee but often to avoid an appreciation in its value.
Full convertibility of the rupee is clearly visible in the horizon. The effects of
these developments are palpable in the explosive growth in the foreign
exchange market in India.
Foreign Exchange Markets in India – a brief background
The foreign exchange market in India started in earnest less than three
decades ago when in 1978 the government allowed banks to trade foreign
exchange with one another. Today over 70% of the trading in foreign
exchange continues to take place in the inter-bank market. The market
consists of over 90 Authorized Dealers (mostly banks) who transact
currency among themselves and come out “square” or without exposure at
the end of the trading day. Trading is regulated by the Foreign Exchange
Dealers Association of India (FEDAI), a self-regulatory association of
dealers. Since 2001, clearing and settlement functions in the foreign
exchange market are largely carried out by the Clearing Corporation of
India Limited (CCIL) that handles transactions of approximately 3.5 billion
US dollars a day, about 80% of the total transactions. The liberalization
process has significantly boosted the foreign exchange market in the
country by allowing both banks and corporations greater flexibility in
holding and trading foreign currencies. The Sodhani Committee set up in
1994 recommended greater freedom to participating banks, allowing them
to fix their own trading limits, interest rates on FCNR deposits and the use
of derivative products.
The growth of the foreign exchange market in the last few years has been
nothing less than momentous. In the last 5 years, from 2000-01 to 2005-06,
trading volume in the than tripled, growing at a compounded annual
rate exceeding 25%. Figure 1 shows the growth of foreign exchange trading
in India between 1999 and 2006. The inter-bank forex trading volume has
continued to account for the dominant share (over 77%) of total trading
over this period, though there is an unmistakable downward trend in that
proportion. (Part of this dominance, though, results from double-
counting since purchase and sales are added separately, and a single inter-
bank transaction leads to a purchase as well as a sales entry.) This is in
keeping with global patterns.
In March 2006, about half (48%) of the transactions were spot trades,
while swap transactions (essentially repurchase agreements with a one-way
transaction – spot or forward – combined with a longer-horizon forward
transaction in the reverse direction) accounted for 34% and forwards and
forward cancellations made up 11% and 7% respectively. About two-thirds
of all transactions had the rupee on one side. In 2004, according to the
triennial central bank survey of foreign exchange and derivative markets
conducted by the Bank for International Settlements (BIS (2005a)) the
Indian Rupee featured in the 20th position among all currencies in
terms of being on one side of all foreign transactions around the globe
and its share had tripled since 1998. As a host of foreign exchange trading
activity, India ranked 23rd among all countries covered by the BIS survey
in 2004 accounting for 0.3% of the world turnover. Trading is relatively
moderately concentrated in India with 11 banks accounting for over 75% of
the trades covered by the BIS 2004 survey.

Outlook
Liberalization has transformed India’s external sector and a direct
beneficiary of this has been the foreign exchange market in India. From a
foreign exchange-starved, control-ridden economy, India has moved on to
a position of $150 billion plus in international reserves with a confident
rupee and drastically reduced foreign exchange control. As foreign trade
and cross-border capital flows continue to grow, and the country moves
towards capital account convertibility, the foreign exchange market is
poised to play an even greater role in the economy, but is unlikely to be
completely free of RBI interventions any time soon.