Financial Integration and the Indian Swap Market Steven Buigut

Assistant Professor of Economics, American University in Dubai, UAE

Vadhindran K. Rao
Associate Professor of Finance, American University in Dubai. P.O Box 28282, Dubai, UAE. Email: vrao@aud.edu Tel: 971-4-318-3114

Abstract: The primary objective of the study is to investigate whether the financial liberalization undertaken in India since the early nineties has resulted in financial integration of Indian markets with global (US) markets to a significant extent. To this end, we will use two approaches. First, we will investigate the relationship between the two main varieties of interest rate swaps in India, namely, the Overnight-Indexed-Swap (OIS) based on the overnight call money rate, and the MIFOR (Mumbai-Interbank-Offer Rate) swap based on the foreign exchange market. Given that the OIS rate can be interpreted as the funding cost for an Indian bank, testing for convergence between the OIS and MIFOR swap curves is a test of covered interest rate parity, and thus of financial integration of the Indian money market with the US money market. A second approach we propose to use is a Vector Error Correction Model (VECM) in order to study the dynamics of Indian swap rates, money market liquidity and US swap rates. The main question is regarding the extent of influence of US swap rates on Indian swap rates. The results have implications for monetary and exchange rate policy.
Keywords: Financial Integration, Covered Interest Parity, Swaps, India JEL Classification Codes: G15, F36, E43

Introduction and Literature Review Indian financial markets have seen a lot of change since the nineties. Administered rates have been abolished, reserve requirements for banks have been decreased, foreign exchange regulations have been eased with the Rupee becoming fully convertible on the current account and partially convertible on the capital account, capital flows have been encouraged by removing restrictions and market-oriented reforms have been instituted including measures to protect investors. Thus, the financial sector has been undergoing gradual liberalization, and it is generally acknowledged that Indian financial markets are now more open (refer to Patnaik and Vasudevan, 1999 and Jain and Bhanumurthy, 2005 for a good review). The main objective of the current study is to investigate whether the financial liberalization undertaken thus far has resulted in financial integration of Indian markets with global markets to a significant extent. An assessment of the extent of financial integration is important as it has implications for monetary and exchange rate policy. For example, the more integrated markets are, the lesser the scope for a country to follow an independent monetary policy. A high degree of integration means that regardless of intervention, arbitrage activities will drive real interest rates into convergence. Similarly, foreign exchange intervention will be ineffective in integrated markets if the exchange rate targeted by authorities is inconsistent with market signals. There are many studies that have investigated financial integration across borders (see Obstfeld and Taylor, 2004 for a good review). Many of them relate to OECD countries, and are based on testing for Covered Interest Parity (CIP), which essentially states that under ideal conditions (such as financial integration and absence of market frictions), the forward premium on a foreign currency would equal the interest rate differential between the two countries. Frankel (1991) studied the CID (i.e., the covered interest differential, which is the difference between the forward premium and the interest rate differential) for a group of developed economies and found that the CID showed a downward trend in about 40% of the cases, suggesting that the countries were getting increasingly integrated over time. Popper (1993) based her test on no-arbitrage conditions relating long maturity currency swaps and bond yields and found support for CIP for longer maturities than a year in all the G-7 countries and the Euromarket. Similar results were found by Takezawa (1995). Obstfeld and Taylor (2004) studied the UK, US and the German markets using a very long time series, and reported that the CIDs became considerably smaller starting in the eighties. Batten and Szilagyi (2006) use daily time series data for the USD/JPY forward market and found that CIP deviations have been virtually eliminated since 2000. Thus, many of the studies set in advanced economies have found support for the CIP. A few studies have also been carried out in the Indian context. Using the CD rate (i.e., the Corporate Deposit rate, which is the rate at which banks borrow from large non-banking corporations) as the domestic borrowing rate and USD Libor as the foreign interest rate, Varma (1997) found the CID to be several times larger than the numbers reported for OECD markets, and attributed this to market frictions. This result was supported by Bhoi and Dhall (1998), who too concluded that Indian financial markets were far from being integrated with global markets, although the various domestic markets (namely, the money market, the government bond market and the corporate bond market) appeared to

be integrated amongst themselves. Mishra et al (2001) provide further confirmation of CIP failure. However, Jain and Bhanumurthy (2005) find evidence of cointegration between the Indian call money rate, US dollar LIBOR (London Interbank Offer Rate) and the dollar-rupee exchange rate, and conclude that the degree of integration seems to be growing. However, they do opine that the integration process is far from complete and recommend that the liberalization process should be accelerated. Similarly, Bhatt and Virmani (2006) basing their regression of the US dollar forward premium on the T-bill interest rate differential between India and the US are unable to reject the CIP, and they cautiously conclude that Indian money markets are getting integrated with global (US) money markets even though the integration is far from perfect. Thus, to date, the Indian studies have found somewhat mixed results. In this study, we take a fresh look at this question of financial integration of the Indian market with the US market. Firstly, previous studies have been based either on the Indian corporate deposit rate, call money rate or T-bill rate, mainly because of the lack of a well-developed term interbank market in India. In this study, we base our tests on the Indian swap market. We believe that swap curve data are better measures of the true cost of funds for a bank in India. Further, using swap curves also allows us to conduct long maturity tests. Secondly, apart from testing for CIP, we also propose to use a Vector Error Correction Model (VECM) to implement a direct test of the extent of the influence of US swap rates on Indian rates. Given that our methods of testing for financial integration are based on interest rate swaps, we start with a brief introduction to the Indian swap market. A swap may be described as a contract between two parties to exchange cash flows based on a formula. A plain vanilla interest rate swap (IRS) involves one party receiving a series of fixed cash flows and paying variable cash flows based on a floating interest rate applied to a notional amount. Interest rate swaps were first introduced in India in 1999, and are largely based on one of two benchmarks overnight MIBOR (Mumbai Interbank Offer Rate published by the National Stock Exchange or NSE), and the six-month MIFOR (Mumbai Interbank Forward Offer Rate), which is a rate implied from the dollarrupee foreign exchange (FX) market. Swaps based on the overnight MIBOR are referred to as Overnight Indexed Swaps (OIS), and those based on the six-month MIFOR are referred to as MIFOR swaps. It is worth noting in this connection that the reason why the swap market is mostly based on one or the other of these two benchmark rates is primarily due to the lack of a well-developed term interbank market. In contrast, the overnight call market is active and liquid and provides a credible benchmark, namely overnight MIBOR. As for MIFOR, this is an innovation that is perhaps unique to the Indian market. Unlike as suggested by its name, it is not directly a market-determined interbank term rate. For maturities up to a year, it is defined and calculated as the sum of the corresponding US dollar LIBOR (London Interbank Offer Rate) and the forward premium on the US dollar against the Indian rupee (INR). The concept of MIFOR rates overcomes the limitation of the lack of a developed term interbank market by exploiting the availability of currency forward premia from a highly active domestic foreign exchange market.

As stated earlier, the primary objective of the current study is to determine whether the financial liberalization instituted thus far has resulted in integration of the Indian financial markets with global markets. We will use two approaches to answer this question. Firstly, we will investigate the relationship between the two swap curves, namely the OIS curve and the MIFOR swap curve. As mentioned above, the short term MIFOR rates are artificial constructions. For example, the 6 month MIFOR rate (on which MIFOR swaps are typically based) is calculated as the sum of 6 month USD LIBOR plus the 6 month dollar-rupee (USD:INR) forward premium. Therefore, the 6 month MIFOR is essentially a covered interest rate. A bank in India that has access to dollar LIBOR funding can borrow dollars abroad at 6 month LIBOR and enter into a 6 month sell/buy FX swap to lock in a covered borrowing rate that is equal to the 6 month MIFOR. Alternatively, the bank can enter into a buy/sell FX swap and invest the dollar proceeds in the money market abroad thus effectively, earning 6 month USD LIBOR plus the 6 month forward premium, which is of course the 6 month MIFOR. As may be inferred from the above, testing for equality between the OIS and the MIFOR swap curves, or more realistically (taking into account market frictions), testing for stationarity/convergence of the spread between OIS and MIFOR rates of corresponding maturities is effectively a test of covered interest rate parity and financial integration. Consider for example the 2 year OIS rate. It is a market-determined rate that contains the markets expectations about the average overnight call money rate over the next two years. The 2 year MIFOR swap rate on the other hand will reflect market expectations about future USD LIBOR rates and the forward premia on the US Dollar in the FX market. Despite the fact that the two swap rates appear to be based on very different variables, there is an arbitrage relationship between them. If the 2 year MIFOR swap rate is higher (lower) than the 2 year OIS rate, then a bank can carry out the following transactions: enter into a receive (pay) fixed 2 year MIFOR swap, thereby paying (receiving) 6 month floating MIFOR, borrow (lend) daily on a rolling basis in the overnight call money market, enter into a buy/sell (sell/buy) 6 month FX swap for placing (by borrowing) funds in the overseas LIBOR market, and enter into a 2 year pay (receive) fixed OIS thereby receiving (paying) the compounded daily overnight rate. The net effect of these transactions is that at the end of the two years the bank will receive (pay) the 2 year MIFOR swap rate and pay (receive) the lower (higher) 2 year OIS rate. Of course, it must be recognized that this arbitrage is not strictly riskless, primarily because there is no guarantee that the daily overnight MIBOR fixing on which the OIS cash flows are calculated will be the very rate at which the bank can borrow (lend) each day. But the risk is small in the sense that the uncertainty regarding cash flows as a result of this practical problem is small, especially given the averaging effect on the deviations over the entire life of the swap. Of course, the same sort of transactions can also be carried out using swaps of longer maturity. Therefore, if the Indian market is sufficiently integrated with the US market, arbitrage considerations should keep the two swap curves from drifting too far from each other.

Data The data to be used consist of the following time series: OIS and MIFOR swap rates, treasury yields of standard maturities, overnight MIBOR (call money rates), and US swap rates. The data will be sourced from the Reuters platform. Methodology Our first approach will be to run stationarity and regression-based tests on the spread between the OIS and the MIFOR swap curves. Under ideal conditions, the spread would be zero. In the presence of market frictions, we would expect the spread to be contained within a band provided markets are integrated to a reasonable extent. The points of interest are a) the width of this band (or the mean and standard deviation of the spread) and b) whether the spread is either stationary or getting smaller over time. Our second approach is to use a Vector Error Correction Model (VECM) to study the time series dynamics of the OIS rates, MIFOR swap rates, money market liquidity and US swap rates. (1) Z t = 0 + 1Z t 1 + ... + p 1Z t p +1 + Z t 1 + t Above Z is a vector consisting of the following: the n year OIS rate, the n year MIFOR rate, the overnight call money rate, the slope of the yield curve and the n year US swap rate, where n will be, by turns, 1, 2 and 5 (three swap maturities with ample liquidity). This is essentially a Vector Autoregression (VAR) model augmented with an error correction term in order to capture the extent of deviation of the variables from their long term equilibrium relationship. It would of course be necessary to confirm the appropriateness of this approach by running suitable stationarity and cointegration tests. Following Huang and Neftci (2006), the slope of the treasury yield curve (as measured by the difference between the 2 year yield and the 3 month rate) and the overnight call money rate are used as proxies for liquidity. Impulse-response analysis will be used to determine the direction of impact of each of these variables on the others. For example, it can be used to confirm whether an easing of liquidity in the money market is associated with a narrowing of the swap spread. Granger-causality tests can be used to determine whether movements in US swap rates have any impact on Indian swap rates after controlling for liquidity conditions. In particular, it would be of interest to test whether US swap rates have any influence on OIS rates over and above the influence they may exert through MIFOR swap rates. Variance decomposition analysis can be used to determine the extent to which the forecast error variance of swap rates is explained by different factors over different horizons. It can thus be used (for example) to determine whether the impact of liquidity shocks is felt mostly in the near term while that of shocks from US rates is dominant over longer horizons. As stated previously, the results of this study have important implications for monetary and exchange rate policy.

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