Does offshore NDF market influence onshore forex market? Evidence from India

• Published date: 01 June 2022
• Author: Harendra Behera,Rajiv Ranjan,Sajjid Chinoy
• Date: 01 June 2022
• DOI: http://doi.org/10.1002/fut.22324

Received: 22 March 2021

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Accepted: 9 March 2022

DOI: 10.1002/fut.22324

RESEARCH ARTICLE

Does offshore NDF market influence onshore forex

market? Evidence from India

Harendra Behera

1

|Rajiv Ranjan

2

|Sajjid Chinoy

3

1

Department of Economic and Policy

Research, Reserve Bank of India,

Mumbai, India

2

Monetary Policy Department, Reserve

Bank of India, Mumbai, India

3

Emerging Markets Asia, Economic and

Policy Research, J. P. Morgan Chase

Bank, Mumbai, India

Correspondence

Harendra Behera, Department of

Economic and Policy Research, Reserve

Bank of India, 7th Floor, Central Office

Bldg, Mumbai 400025, India.

Email: hbehera@rbi.org.in

Abstract

The paper uses a vector error correction model–multivariate generalized

autoregressive conditional heteroskedasticity approach to examine the

interrelationship between onshore and offshore nondeliverable forward

(NDF) markets for the Indian Rupee. The empirical results suggest a stable

and bidirectional long‐run relationship between onshore and offshore

markets. The subperiod analysis implies that there are unidirectional mean

spillovers from NDF markets to onshore spot, forward, and futures markets

during the post‐taper tantrum period. Regarding “volatility spillover,”the

analysis indicates a unidirectional volatility spillover from spot and forward

segments to NDF market in normal circumstances, which turns bidirectional

during times of depreciation pressure on the rupee.

KEYWORDS

foreign exchange market, MGARCH, NDF, offshore market, spillover

JEL CLASSIFICATION

E44, F31, G14, C32

1|INTRODUCTION

Emerging market economies (EMEs) have, in general, experienced a sharp and sustained rise in trade and capital flows over

the last three decades, reflecting a confluence of factors: improved domestic economic prospects, liberalization of their external

sectors, and a gush of global liquidity that advanced economy central banks have injected by aggressively expanding the ir

balance sheets after the global financial crisis. This has correspondingly raised nonresident interest in emerging market

currencies, both for risk management and speculative ends. The electronification of trading has provided a further b oost to

demand for EME currencies (Wooldridge, 2019). Rising interest in these currencies, however, is often offset by capital controls

and underdeveloped onshore financial markets. All these developments have given birth to a parallel mark et for EME

currencies in offshore centers known as nondeliverable forward (NDF) markets. In NDF markets, trading is settled in a

convertible currency, usually in US dollars, as nonconvertible currencies are restricted to be delivered offshore. As documented

by a report of the Reserve Bank of India (2019), the rising prominence of NDF markets could be mainly on account of

restrictions on foreign exchange transactions, complex documentation process, and Know‐Your‐Customer (KYC)

requirements, restrictions on market participants (especially, nonresidents) in hedging activities, cancellation and rebooking

of contracts, permission to participate in various existing derivatives product offered by the market regulators, a nd

inconvenient market hours for those in other time zones.

Over the years, trading in EME currencies in offshore centers has increased significantly. As per the latest Triennial

Survey of the Bank for International Settlements (2019), for example, turnover in offshore markets for the Indian

J Futures Markets. 2022;42:1167–1185. wileyonlinelibrary.com/journal/fut © 2022 Wiley Periodicals LLC

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Rupee (INR) outpaced that of the onshore market. When the NDF market volume is substantial or larger than that of

the onshore market, price discovery can get fragmented wherein domestic market price discovery becomes vulnerable

to influences from price discovery in the offshore market. The presence of a large offshore market therefore sometimes

weakens the efficacy of exchange rate management by a central bank and/or hinders the pursuit of domestic financial

stability objectives.

Against the aforementioned backdrop, this paper tries to examine the linkages between onshore and offshore

markets for the INR, and whether there is a long‐run relationship between the two markets? Second, if so, what is the

degree and directionality of influence? Third, whether the volatility in the onshore market is driven by that of the

offshore market? Fourth, if so, how does this change over different time periods—in “normal times”versus “stressed

times”? As the sample period of our study contains the phases of tranquillity and turmoil in the financial market, we

divided the sample period into five subperiods motivated by the events like global financial crisis, European debt crisis,

taper tantrum, and mayhem in financial market of the EMEs during summer of 2018. The exact date of each subperiod

is identified by conducting a structural break test in the exchange rate series.

The remaining part of the paper is organized as follows. Section 2reviews the literature, while Section 3presents some

stylized facts of the INR NDF market. A theoretical background behind our empirical ana lysis is outlined in Section 4,while

methodological details are provided in Section 5. Data and our empirical results are discussed in Section 6.

2|REVIEW OF LITERATURE

The origin of the NDF market actually dates back to the 1970s in response to the capital controls in Australia (Debelle et al.,

2006). These markets then started growing in Latin American countries during the 1990s and subsequently expanded

rapidly in Asia and Eastern Europe. Analysts and policymakers began recognizing the presence of NDF markets and their

interrelationship with onshore market across several countries and regions, including Asian currencies (Colavecchio &

Funke, 2008;Gu&McNelis,2013;Ma&McCauley,2013;Maetal.,2004), the Korean Won (Park, 2001), the Chinese

Renminbi (Colavecchio & Funke, 2008;Dingetal.,2014;Fungetal.,2004; McCauley & Shu, 2019;Suetal.,2019), the INR

(Behera, 2011; Goyal et al., 2013; Guru, 2009; Kumar & Jain, 2018; Misra & Behera, 2006), and the Indonesian Rupiah

(Cadarajat & Lubis, 2012). Various empirical studies found an impact of offshore markets on the onshore forward market

(Cadarajat & Lubis, 2012;Park,2001;Wangetal.,2007), onshore spot market (Behera, 2011, Goyal et al., 2013; Reserve

Bank of India, 2013), and onshore futures market (Behera, 2011). Conversely, a few studies found evidence of the domestic

market influencing the NDF market (Misra & Behera, 2006;Wangetal.,2007).

The empirical literature on investigating the relationship between onshore and offshore markets has proliferated

around the world over time, the studies on INR remain sparse, dated, and inconclusive. Since the early findings that

onshore markets influence the NDF market, between 2004 and 2007, on account of restricted participation of domestic

players in the offshore market (Misra & Behera, 2006) to increase in the magnitude of volatility spillover after the

introduction of currency futures in 2008 (Behera, 2011; Guru, 2009; Saravanan & Shanmugam, 2017), the role of

offshore markets has increased in the price discovery process of onshore markets (Darbha, 2012). Kumar and Jain

(2018) investigate the interrelationship between spot, forward, and NDF markets and conclude that the relationship

between the three markets is dynamic owing to the policy measures taken by RBI to curb volatility. Finally, Goyal et al.

(2013) find a long‐term relationship between NDF and onshore markets, and provide evidence that the relationship is

bidirectional, as both markets adjust to any deviations from the equilibrium state. Their study also finds that shocks

originating in the NDF market carry more information during periods of depreciation, leading to mean and volatility

spillovers in corresponding onshore segments.

All told, therefore, the evidence on India is patchy, inconclusive, and largely dated. This paper attempts to add to

the evidence on this topic by analyzing a larger data set, using more advanced econometric techniques

(VECM–MGARCH vs. VAR–MGARCH), as well as leveraging the latest information from the BIS Triennial Survey.

3|STYLIZED FACTS

India's onshore foreign exchange (forex) market is primarily a wholesale market, dominated by banks, forex brokers,

and corporate clients. Individuals, the government, and the central bank generally transact through banks. Forex

trading typically takes place over‐the‐counter (OTC) for spot, forward, and swaps, while options and futures are traded

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BEHERA ET AL.