A new breed of foreign traders in bond market weakens rupee

MUMBAI: A new breed of foreign momentum traders in the Indian bond market is fuelling the current volatility in the rupee. They rush in to buy debt papers when they sense an opportunity, take bets on rupee in the unrecognised offshore market, and then suddenly exit to make a killing on the currency. They represent hot money in bonds.


These are FII proprietary debt investors, unlike the 'broadbased' FIIs that pool in money from rich clients across the world. While prop FIIs have always been around, their trading style has undergone a change in the last one-and-a-half months after the government raised the FII investment limit in government and corporate bonds, and simultaneously simplified the trading rules.

These foreign investors straddle two markets - the local securities and the offshore rupee/dollar forward, known as non-deliverable forward market. Their abrupt sell-offs could mean a small currency loss, like the trades that happened since the third week of May when they sold bonds and pulled out money when the rupee was lower compared to the exchange rate at the time they bought bonds a month ago.

But the loss (in selling bonds in India) was more than compensated for by gains booked in NDF trades that are cut in Singapore, London and Hong Kong. Having opened the debt market to FIIs of various kinds, chances are that the rupee may have to suffer a new kind volatility - a change that could delight punters but make life more difficult for corporate treasurers as well as the Reserve Bank of India, which refuses to openly acknowledge the impact of NDF trades, let alone talk of intervening in the NDF market.



What's the game being played by these FII prop traders? Consider some of the typical trades that have happened in early May. A cut in withholding tax (the tax that is deducted before remitting the interest on bonds to overseas investors) and Unilever Plc's announcement to hike stake in Hindustan Lever pushed up rupee amid expectations of a surge in dollar inflow. At this point, say on May 7, a prop FII trader makes her entry. The FII buys bonds in India when the spot rupee is trading at 54.13 and simultaneously buys one-month dollar forward in the NDF market. (As the name suggests, all deals in the NDF market are forward deals settled in dollars; it's not a spot market because the rupee, a non-convertible currency, cannot be 'delivered' abroad.)

Now, the NDF market is pro-cyclical market - when there is bullishness on the rupee, the Indian currency trades stronger in NDFs than locally. So, on May 7, the one-month forward in India was 54.46, while in NDF it was 54.12. The trader holds the bonds for about a month; by then, the rupee has considerably weakened against the dollar, thanks to a global dollar strengthening, coupled with the noise on India's current account deficit. On June 7, the spot rupee was down to around 57, while in the NDF market the one-month forward was trading at 57.65.