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A blog on financial markets and their regulation
Rajan Goyal, Rajeev Jain and Soumasree Tewari have an interesting paper in the RBI Working Paper series on the “Non Deliverable Forward and Onshore Indian Rupee Market: A Study on Inter-linkages” (WPS(DEPR):11/2013, December 2013).
They use a error correction model (ECM) to measure the linkages between the onshore and offshore rupee markets. The econometric model tells a very simple story: in normal times, much of the price discovery happens in the onshore market though there is a statistically significant information flow from the offshore market. But during a period of rupee depreciation, the price discovery shifts completely to the offshore market. (While the authors do not explicitly report Hasbrouk information shares or Granger-Gonzalo metrics, it seems pretty likely from the reported coefficients that the change in these measures from one regime to the other would be dramatic).
My interpretation of this result is that the exchange control system in India makes it very difficult to short the rupee onshore. The short interest emerges in the offshore market and is quickly transmitted to the onshore market via arbitrageurs who have the ability to operate in both markets:
On the other hand, during the stable or appreciation phase, there is no need to short the rupee and divergent views on the rupee can be accommodated in the onshore market in the form of differing hedge propensities of exporters, importers and foreign currency borrowers.
Short sale restrictions in the onshore market have two perverse effects: