A child’s guide to restrictions on forex forward market

Aseni, the whiz kid interested in learning everything economic, is in conversation with her grandfather, Sarath Mahatthaya, on the Central Bank’s prohibition of commercial banks from entering forward foreign exchange contracts for three months on the ground that market has excess volatility and it is risky for banks. Here is the interesting discussion:

• Is it a flat earth sitting on four towers of turtles?

Aseni: Grandpa, the Central Bank, known as CBSL, has recently issued a directive prohibiting commercial banks from entering forward foreign exchange transactions for three months. I read it on CBSL’s website at: https://www.cbsl.gov.lk/sites/default/files/cbslweb_documents/laws/cdg/Banking_Act_Directions_No_2_of_2021.pdf. It says that the measure has been taken to avoid excess volatility in the forex market and help banks do better risk management. I am confused because I do not understand how this measure would help the attainment of the two objectives mentioned. Can you clarify it for me? 

Sarath: Markets are not like the still waters of a lake. The conditions for a market to remain still change every moment and as a result they are in a continuous flux. This flux enables a market to move from one position to another. Since markets are like a living animal, the change is necessary for it to show that it is alive. This change in the market from time to time is known as volatility, a state in which a market has continuous ups and downs. And for a healthy and growing market, volatility is necessary. Everyone knows that when waters in a lake are still, underneath it, a lot of acrid elements grow causing the lake to die. Same will happen to a market also when volatility is stopped. 

Take for example a baby. A healthy and growing baby is always in action. It cries or laughs. It continuously dances its legs and arms in the air. It is positively responsive to its Mom’s appearance, smell and the look. If a baby remains still, that baby is sick, and needs medical treatment. Hence, CBSL should not seek to eliminate volatility in the market. Instead, it should welcome volatility because it is a sign of market’s health and its desire to grow. 

Aseni: But Grandpa, CBSL is not against volatility. It is against excess volatility. Isn’t there a case for CBSL to eliminate excess volatility? 

Sarath: There is a problem here because no one knows how to define excess volatility. Is it 1%, 5%, 10%, or above that level? It is an arbitrary decision. If a market moves up and down extremely high within a short period, then, it is not conducive for its smooth functioning. That is because everybody, caught up by surprise, will run for cover just like when a country is being hit by a tsunami. When it happens, the market participants will lose their sanity. The presence of a set of insane participants is the biggest threat to the functioning of a market. 

Hence, there is a case for CBSL to intervene to prevent it because its interest is to allow markets to perform at the least cost to every market participant. When there are extreme ups and downs, there are some who profit from them at the expense of others. All regulators want to keep those losses and gains at a minimum so that the economy would continue along its long-term growth path. But extreme ups and downs are the reaction of the market to some extreme measures taken by regulators. Therefore, regulators should first examine their own contribution to extreme volatility and remove those causes so that in the long run the market can get onto its own natural growth path. That is the sign of any healthy and growing market. 

Aseni: Grandpa, what you mean is that CBSL has overreacted to its own folly without trying to correct it. But what is its contribution to present excess market volatility?

Sarath: Before we come to that topic, let’s have a little digression to understand what is meant by forward market of foreign exchange and how it operates. At the end, you will realise that the forward market is an important part of the whole foreign exchange operations and if you suppress it for whatever the reasons you are simply stunting the development of the market.

Forex market is made up of a large number of buyers and sellers of foreign currencies. The market is facilitated by commercial banks which function as market dealers. In this role, they buy foreign currencies from customers and sell the same back to those who want to buy them. Their profit is, like any other trader, the difference between the buying and selling rates. Thus, they buy at a lower rate and sell at a higher rate. That is how you get two rates quoted in the market as the buying rate and the selling rate. If anyone is interested in learning of the prevailing exchange rate, he should look at the middle rate between the two. The buyers in the market are basically those who want to import goods and services from foreign countries to Sri Lanka. In the opposite, sellers are those who earn foreign exchange by exporting goods and services to foreign countries. Commercial banks buy foreign currencies from exporters and sell the same to importers. 

If the buying orders are matched by selling orders, there is no problem. But the problem arises when the buying orders are more than the selling orders or vice versa. In the first case, the shortage of foreign currencies in the market causes the exchange rate to depreciate. In the latter, the surplus of foreign currencies in the market leads to the appreciation of the rate. If these shortages and surpluses are a temporary thing, CBSL can either supply forex from its reserves to meet the shortage or buy the surplus in the market and add to its reserves. In that way, CBSL’s intervention will smoothen the exchange rate movement. 

But if it is a chronic situation, CBSL cannot exhaust its reserves by selling them in the market or continuously buying surpluses because it causes an increase in money supply when CBSL issues rupees to buy them. In this situation, as Sri Lanka is faced with today, CBSL has to allow the exchange rate to change. It must allow the rate to depreciate if there is a continuous shortage and, in the opposite, allow the rate to appreciate if there is a continuous surplus in the market. 

This market is called the spot market and its feature is that buying and selling transactions are completed in two working days. But the forward market is different from this.

Aseni: How does the forward market operate?

Sarath: ‘Forward’ means something that happens later or on a future date. In the forward market, buyers enter forward purchase contracts with commercial banks and sellers, forward sale contracts. They agree on an exchange rate which is close to the current spot rate and complete the transaction on a future date at that exchange rate. Hence, the delivery of foreign currencies in the forward market happens on a future date, maybe, in one month, three months or six months as agreed. 

Suppose that an importer of sugar wants to pay his supplier after three months. Instead of buying dollars today and keeping them in idle form for three months, he enters a forward purchase contract with his bank. He buys dollars after three months at the rate agreed in the contract. In the opposite, an exporter can enter a forward sale contract to sell foreign currencies after three months but at the rate agreed in the contract. Thus, the forward market is a mechanism to take the risk of currency depreciation or appreciation away from buyers and sellers. And that risk mitigation mechanism is a must, and it should not be stunted. 

Aseni: You said that the rate at which forward transactions are completed is the one agreed in the contract. But how do you decide on that rate? Is it simply the spot rate or some rate different from it?

Sarath: In most times, it would be different from the current spot rate. There is an extreme case where it would be the current spot rate, but I will explain it later.

Suppose an exporter earns one US dollar by exporting a shirt to USA. He has the choice of immediately selling it to a bank at the spot rate and getting rupees or keeping the dollar in a US account and bring it after three months. If he expects the rupee to appreciate against the dollar during this period, it is better for him to enter a forward sale contract. In that way, he will sell the dollar after three months, but get the rate agreed today and not the appreciated rate in three months’ time. But before making that decision, he should compare the interest rates in Sri Lanka and interest rates in USA.

Suppose for simplicity the current spot rate is Rs. 200 per dollar, the three-month US interest rate is 1% and that in Sri Lanka is 10%. If he immediately brings that dollar to Sri Lanka, converts it to rupees at 200 per dollar and keeps it in an account for three months, at the end, he will get Rs. 220. But if he keeps the dollar in a US account, after three months, he will get one dollar and one US cent. The forward rate should even out these losses and gains and make both options equally profitable. To do so, the forward rate should differ from the spot rate by the interest rate differential.

The rule of thumb is that if the local interest rate is higher than the foreign country interest rate and the exchange rate expressed as the amount of local currency per unit of foreign currency, the forward rate should be at a premium over the spot rate. In the above the example, this is roughly about Rs. 218 per US dollar, arrived at by dividing Rs. 220, spot rate plus local interest income for three months, by $ 1.01, US dollar income plus US interest income. In this example, the interest differential is 9% in favour of Sri Lanka rupees. If the local interest rates are lower than the foreign interest rates, it should be at a discount over the spot rate, again when the exchange rate is expressed as the amount of local currency per unit of the foreign currency. If interest rates are the same, then, both spot rate and forward rate would be the same. 

Thus, the forward market is not an evil thing. It is simply a reflection of the domestic interest rates as against foreign interest rates. Since Sri Lanka has gone for a low interest rate policy regime, it has discouraged exporters to bring in foreign currency immediately if they have expected the exchange rate to depreciate in the market. They can keep their dollars out, borrow in Sri Lanka at low interest rates to meet their local expenses and bring in the dollars once the rate has depreciated. On the other hand, it has encouraged importers to go for forward purchase contracts because the forward premium payable is less than the expected currency depreciation. That is why there has been a rush to go for forward purchase contracts by importers. 

Aseni: I now understand that the proper policy for CBSL would have been to increase the interest rates locally as a deterrent for importers to go for forward purchase contracts and for exporters to keep their dollars in foreign countries. So, suppressing the forward foreign exchange market is not the proper strategy, is it? 

Sarath: Yes, it is. But CBSL has been moving from one mistake to another. Its action is like the argument of that old lady that the earth is flat and sits on four towers of turtles.

Aseni: A story of a flat earth sitting on four towers of turtles? Interesting. What is that story, Grandpa?

Sarath: In this story, a scientist had delivered a lecture to a group of old ladies on the shape of the earth. When he had said that the earth was round, one smart lady had risen to her feet and countered him. She had said that the earth was in fact flat and it sat on four turtles that held it at the four corners of the flat earth. The scientist thinking that he could outsmart the old lady had asked the question, on whom those four turtles were sitting. The reply immediately came that on four other turtles. When asked on whom those four other turtles were sitting, the reply came that on four other turtles. The questioning had gone on and the lady had filled it with the same answer: ‘four other turtles were sitting on four other turtles’. Finally, it was an unending four towers of turtles on which the flat earth was sitting. Since there was no end to it, the scientist had finally given up and allowed the old lady to gain victory. 

Aseni: Amazingly smart old lady! But how does it relate to the continuous mistakes made by CBSL?

Sarath: The scientist had forgotten to ask one important question. That was, whether those turtles were strong enough to bear the burden above them and what would happen if one turtle got crushed under the burden of the turtles above it. Since the turtles were living beings, it was natural that they could not hold on to the burden forever. It would be sufficient for only one turtle to fail for the whole earth to be shattered to pieces like a building collapsing to the ground because it cannot bear its own burden. Similarly, CBSL has also created four towers of turtles by moving from one mistake to another. The chances are that if any of the mistakes gets blown, the whole system would collapse under its own burden. 

Aseni: But how should CBSL avoid it?

Sarath: By having a clearly identified exit mechanism for its unruly interventions in the market. Normally, this does not happen until a foreign source, like IMF, comes to bailout the country’s dying economy. That was the past experience of Sri Lanka.

(The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected].)