Indian Financial Integration: Evidence from the NDF Market


Vineet Srivastava1*, Arup Chattopadhyay2

1Research Fellow, Department of Economics, The University of Burdwan,

Golapbag, 713104, West Bengal, India.

2Professsor, Department of Economics, The University of Burdwan, Goplapbag, 713104, West Bengal, India.

*Corresponding Author Email:



This study seeks to investigate the extent and causes of financial integration of India with the rest of the world during the sample period of January 2000 to October 2017. The study compares the interest rate which ought to prevail, with respect to the Non-Deliverable Forward (NDF) rate, in case of Covered Interest Parity and what actually does prevail. The difference between the Covered Interest Parity implied domestic interest rate and the actual domestic interest rate is our measure of financial integration. The study tries to find out different macroeconomic variables which affect the financial integration of India. The study used ordinary least squares, Johansen’s Cointegration technique along with VECM and Granger causality to unearth the long run and short run relationship of financial integration with plausible macroeconomic variables. We found India to be significantly non-integrated. Inflation volatility, changes in NEER and GDP along with Bank Rate and CRR were found to unequivocally influence financial integration of India. We also found structural break present in variables under study at June 2008.


KEYWORDS:  Financial integration, Covered interest parity, NDF, Structural break, Cointegration, VECM.




Emerging market economies like India, while undertaking economic reforms made integration of the economy with the world economy an important agenda. Progressive liberalization of the current as well as capital account was also undertaken. The Indian foreign exchange market also witnessed a metamorphosis from a heavily guarded foreign exchange regime to a more open and market oriented one (Misra and Behera, 2006). However in the recent aftermath of sub-prime lending crisis countries have become a wary of unbridled flow of funds across borders because of the risks associated with it.


Risks include high degree of concentration of capital in certain countries, the pro-cyclical nature of short term capital flows and the risk of abrupt reversals, possibility of contagion effects etc. (Dadush, Dasgupta and Ratha, 2000). For policymakers the issue of financial globalisation also holds a special significance because of its immediate relevance and disparate effects on countries practicing it, specially the emerging ones (Kose, Prasad Rogoff and Wei 2009). The amount of financial integration also has a significant bearing over the conduit of monetary policy in the economy (Higgins and Humpage 2005). It is all the more important after the sub-prime lending crisis as to see how the countries, in our case India, has fared i.e. whether it has increased or decreased association with the world financial markets.


Against this backdrop this study tries to measure the extent of financial integration of India with the world along with its time behavior and especially in the aftermath of US sub-prime lending crisis, and establish its economic determinants. In order to measure the amount financial integration there are a number of quantitative and qualitative measures present. We employ a price based approach of establishing Covered Interest Parity (CIP) to measure the extent of integration of the Indian financial market with that of the world. With rapidly increasing cross border trade and evolving currency market, India being circumspect of the open financial borders, has put semi-permeable controls like the partial convertibility of Rupee in the capital account. Hence disallowing the hedging opportunities to foreign investors as a result of which offshore markets for Non-Deliverable Forwards (NDF) have developed. Due to the growing activity in the NDF market and it being relatively unexplored in the Indian context encouraged us to include it in our study. We also try to explore the possibilities of long run association of the non integration with other macroeconomic variables. Section 2 of the paper presents literature surveyed for this study. Section 3 deals with the data and methodology used in the study. Section 4 presents the results and discusses the same. In Section 5 we provide concluding remarks and also discuss the limitations of the study.



Among various measures of financial integration Frankel (1992) claimed of the condition ‘that the covered interest differential is zero, is an unalloyed criterion for "capital mobility" in the sense of the degree of financial market integration across national boundaries.’ It is also considered closest thing to a physical law in international finance by Borio, McCauley, McGuire and Sushko V (2016). Covered Interest Parity (CIP) has generally been established by using the usual variables and the onshore forwards rate like (Taylor M. P., 1987), (Baba & Packer, 2009) among many others. Some studies took cognizance of the suitability of the Non-Deliverable Forwards (NDF) in markets where credit migration across borders was constricted by decree, and incorporated it in the examination of the CIP. Studies in the Indian context was done by Ma, Ho and McCauley (2004) where a number of other Asian currencies were also examined noting the declining interest rate spread for the Indian economy in the study period of January 1999 to February 2004 whereas Misra and Behera (2006) used NDFs to calculate the onshore/offshore interest rate spread for the Indian economy during the period of November 2004 to January 2007. They reported non-zero spread between the implied yield in the forward and NDF market hence indicating the presence of capital control and segmented financial markets. Hutchison, Pasricha and Singh (2012) also study the Indian capital controls along with that of the Chinese. They find significant reductions in the arbitrage barriers since 2009 indicated by the deviations from the Covered Interest Parity (CIP) also noting the asymmetric nature of barriers on capital inflows and outflows.

A number of studies were consulted to find out what variables influence the covered interest differential. Studies have tried to explain the deviations of CIP equilibrium from its theoretical limits. Frenkel and Levich (1975) in their paper provide a procedure for estimating transaction costs in the market for foreign exchange and securities. He asserts that any deviation from the theoretical limits of the CIP may not be taken as an opportunity for unexploited profits. There may be other factors such as lags in executing arbitrage or differences in demand and supply elasticity in various markets as well as presence of transactions costs. Hence there is band within which the forward premium may deviate without violating the parity theorem. Earlier empirical studies of Branson (1969) has attributed deviations from interest parity to transactions cost while in later studies by Oskooee and Das (1985), Clinton (1988) play down the role of the such costs. Aliber (1973), Dooley and Israd (1980) has stressed the role of political risk for aberrations from parity which was corroborated by Coffey, Hrung and Sarkar (2009) where deviations of Covered interest differential was found to be caused by counterparty risk in the face of crisis in the world financial market. Taylor (1989) observes that market turbulence as well as length of maturity of assets is positively related to the profitable arbitrage opportunities in the markets. Borio et. al (2016) attribute demand to hedge USD forwards and proxies for the risks associated with CIP arbitrage better explains the deviations from CIP than bank credit and liquidity conditions. Fixed income spreads and nominal interest rates were two factors were identified by Du, Tepper, Verdelhan (2018) by again discrediting any role by transactions cost or the credit risk posed for influencing the deviations in the parity. Studies estimating and examining CIP in the Chinese context by Cheung and Qian (2010), Cheung and Herrala (2014) tried to explain the deviations by several macroeconomic and country risk factors. The latter study found credit market tightness indicators and NEER to have an influence on the CID whereas the former got more macroeconomic variables that influence the differential including the capital flight variable. Both studies found the CID to be persistent.


Using onshore data Ferreira (2011) establishes that earlier members of European Union have CIP across all maturities; countries where CIP does not hold are inferred to have incomparable assets or data. Skinner and Mason (2011) found that CIP holds for advanced economies whereas it did not hold for emerging economies for longer maturities. The causes are found to be various aspects of credit risk rather than the transactions cost. Another paper by Casavas (2012) established the no arbitrage condition in CIP by appending a band around which deviations could take place. The study is for developed economies during the year 2008-2011.


Bhatt and Virmani (2005) studied India’s money market integration with the world by measuring the uncovered as well as the covered interest parity. He found the CIP to exist, albeit weak, and UIP failing to hold during April 1993 to March 2002, ascribing the cause of which to existence of exchange risk premium over and above the expected depreciation of currency. Jain and Bhanumurthy (2005) found that there is a strong integration of the domestic call money market with the London Interbank Offered Rate (LIBOR). Misra and Mahakud (2009) observed violation interest parity in their study spanning April 1993 to March 2003.



In case of Covered Interest Parity (CIP) using the off-shore market equation 1 holds:


where  is Non-Deliverable Forward rate of one-month maturity given at time t, the symbol  represents the interest rate prevalent at home, if is the foreign interest rate given by the London Interbank Rate (LIBOR) and St is the spot exchange rate. We transpose the above equation to find out the implied home interest rate given the spot exchange rate, NDF and foreign interest rate LIBOR. Under perfect integration of the markets, such implied interest rate obtained would exactly be equal to the actual interest rate prevailing at home. In other words, if we take a difference between the implied interest rate and the actual interest rate prevalent at home the result would be zero. Hence we rearrange the equation to arrive at the INR covered interest differential, henceforth referred differential as:



In addition to the already explained symbols, it, t+1, ON is the actual onshore interest rate which is taken to be the Mumbai Inter Bank Rate (MIBOR). The differential so obtained gives the magnitude of aberration found in the ideal interest rate and the actual one. We shall calculate the differential over a period of time to see how it has evolved. We have a sample of monthly data from January 2000 to October 2017 comprising 214 data points each for NDF, LIBOR, MIBOR and Spot USD-INR exchange rates.1 The covered interest rate differential, henceforth referred to as differential, calculated as above is known to exist in presence of country and counterparty risk Coffey, Hrung and Sarkar (2009), Dooley and Israd (1980). Following a study by Cheung and Qian (2011) on Chinese covered interest parity we take INR USD Exchange rate Volatility (ExV), Change in Real Gross Domestic Product (dGDP), Inflation Volatility (InfV), Change in Nominal Effective Exchange Rate (NEER) as variables that can explain the differential.2 The GDP at factor cost was available with quarterly frequency, hence it was converted to monthly frequency by the method provided by Chow and Lin (1971). With the help of variables closely related to the GDP and available at monthly frequency, GDP at monthly frequency was interpolated.3 Following Jeane (2012) and Cheung and Herrala (2014) we consider more economic determinants for explaining the differential. Change in Volatility Index (VIX), Change in Bank Rate (dBR), Change in Cash Reserve Ratio (dCRR), Change in Exports (dX), Change in Imports (dM) are taken into account.4 S & P 500 VIX is also taken into consideration to account for global volatility. Two credit market liquidity indicators are used to see if they have any bearing on the Zt.


On ordinary least squares (OLS) estimation it was inferred from the value of the Dubrin-Watson statistic that the model suffered from autocorrelation problem. Such autocorrelation might be because of interpolated data used or the non-stationarity of the dependent variable (Gujrati, Porter and Gunasekar, 2012). In order to tackle these problems we perform the Cocharanne-Orcutt two-step procedure (Cochranne & G.H, 1949). The said procedure not only corrected serial autocorrelation in our case but also rendered the dependent variable stationary. The corrected variable will be depicted by .


However, the above analysis does not account for the possible break in the variables. To that end, we first undertake the Quandt-Andrews structural breakpoint test. After settling the breakpoint in the data we go on to estimate the equation taking into account the discontinuity in the regression. Following Stock and Watson (2011) we build an interaction variable by building a dummy and multiplying it with the ‘discontinuous’ variable which takes the value zero before the break and value one after the break. Such interaction variables along with the original variables are regressed on the dependent variable, . The coefficient of the  of the respective variable represent the post-break scenario while other variables are interpreted as usual. We consider first giving a regression to macroeconomic volatility indicators of the Indian economy.



We further use Equation 4 as a general specification to gauge the effects of additional economic determinants along with those mentioned in equation 3, on the Differential



Where  is a vector which includes other economic variables in addition to the above macroeconomic stability proxies, are the vector of relevant interaction variables. Further variables which are integrated of order one are employed to test the long run association among them by the Johansson’s Cointegration test. To see the short-run dynamics and causation we test VECM along with the Ganger causality test.



The MIBOR is everywhere greater than the LIBOR. The two variables appear to co-move till March 2009 but dissociate with each other afterwards. The differential, calculated by equation 2, remains positive throughout the sample period. Its level however decreases till mid 2006, registers high fluctuations for the next three years and then starts breaking away to increase for a sustained period of time. Such increase coincides with the time when the US sub-prime lending crisis had hit the financial world. Increased magnitude of the differential around that time might be because of fund reversals from the emerging economies such as India, leading to a high domestic interest rate and hence a greater interest rate cleft leading to greater non-integration of Indian financial markets with the rest of the world.


Before we start to determine factors affecting the differential we perform an endogenous structural breakpoint test, the Quandt-Andrews breakpoint test which establishes the structural breakpoint at June 2008. The estimated Maximum LR F-statistic (2008M06) has value 6.457538 and the corresponding p-value of 0.00, furthermore Maximum Wald F-statistic (2008M06) has the value of 64.57538 and p-value of 0.00 hence rejecting the null hypothesis of no structural break. The other reported variables also indicate presence of a structural break. The test was conducted with standard 15 per cent trimming.


The differential starts breaking away from the trend to decrease for a couple of quarters and then rise. Table 1 presents the summary statistics of the variables used in explaining the CID, including the differential, where it is also noted that all the variables are stationary and integrated of order zero. To establish the determinants of the interest rate gap we estimate equation 3 and equation 4 by OLS, results of which are presented in Table 2. Among the macroeconomic stability variables presented in Column 1 of Table 2, we see  and  have positive and significant coefficients implying instability in the economy which leads to rise interest rate cleft depicted by a rise in  in the post-break scenario.  also has expected sign of the coefficient indicating strengthening Rupee leads to more financial integration. The second column of Table 2, which considers additional variables, reports and  to have the significant positive and negative coefficients post break. We observe that the change in trade variables  and  show opposite effect on the differential while gives expected negative significant coefficient.


In order to further investigate the causes that drive the difference between the interest rates we resort to Johansen Cointegration test. Results of unit root tests are presented in Table 3, to find out I(1) variables to consider testing three models where variables of different nature are tested to see if they have any long run equilibrium relationship exists. First model is where  and  are considered, they being a part of macroeconomic stability variables. Model II considers  and , the trade variables. Model III sees whether is has a long run relationship with the credit market tightness indicator viz. and .The result for Johansen Cointegration is presented in Table 4.


Table 1: Descriptive statistics of the variables:























































Std. Dev.












































































































Source: Mentioned in the text.

Note: Figures in parentheses in the last two rows are the p-values. ADF and PP test are done at level and including intercept term only.


Table 2: Results of the regression on Differential Zt*


























































































Adjusted R2



Breusch-Godfrey LM test

(H0: No serial correlation)





Breusch-Pagan-Godfrey test

(H0: Homoskedasticity)





No. of observations



Source: Authors’ estimation.

Note: Standard errors are presented in parentheses. BG-LM and BPG test present the F-statistic with p-value in the parentheses. ‘***’ denotes 1% level of significance, ‘**’ denotes 5% level of significance and ‘*’ denotes 10% level of significance


Table 3: Result of unit root test on variables

ADF at level

ADF at 1st difference

PP at Level

PP at 1st difference

Order of integration

























































































Source: Authors’ estimation.

Note: ADF- Augmented Dicky-Fuller; PP- Phillips-Perron. t-values are reported with p-values in parentheses.


Table 4: Results for Johansen’s Cointegration Test

Model I*

Model II**

Model III

Hypothesised no. of CE(s)

Trace statistic

Max Eigen Statistic

Trace statistic

Max Eigen Statistic

Trace statistic

Max Eigen Statistic


59.15962 (0.0000)

43.82692 (0.0000)

68.69294 (0.0000)

50.15565 (0.0000)

31.76012* (0.0293)

16.77112 (0.1831)

At most 1

15.3327 (0.0529)

11.97011 (0.0529)

18.53729 (0.0168)

15.38864 (0.0331)

14.989 (0.0595)

11.57118 (0.1278)

At most 2

3.362587 (0.0667)

3.362587 (0.0667)

3.148659 (0.076)

3.148659 (0.076)

3.417818 (0.0645)

3.417818 (0.0645)

Source: Authors’ estimation.

Note: ‘*’ and ‘**’ indicates presence of one and two co-integrating relationships at 5 percent level of significance. Model I and II uses the SIC while Model III uses the AIC criterion for optimal lag length determination.


From Table 4 it is seen that there are one and two cointegrating equations in the models under study. We perform the VEC estimations to find the significance of association between variables. The long-run cointegrating equations obtained from VECM estimations are presented below with their absolute t-values given below their coefficients.


Model I

Model II


Model III


We see expected signs of long run relations of Zt with GDP and NEER, indicating that as the economy’s output rises and currency strengthens in the long run the differential narrows, implying greater integration. In Model III tightening credit market in the form of increased BR raises the differential but the other indicator has an opposite effect. Higher import is also seen to widen the differential. It must however be noted that even though the error correction term for the first two models are negative, it is statistically significant for the second model’s first equation only with value -0.07954 and absolute t-value 2.55693. The third model’s error correction term has positive and insignificant coefficient hence ruling out any long-term causality5. In order to delve deeper into causation and short run dynamics, we test for Granger causality.

Table 5: Results for Granger Causality Test


Dependent Variable


Model I

Model II

Model III

Excluded Variables


































Source: Authors’ estimation.

Note: Values reported are Chi-squares with their p-values in parentheses. Lag length for Model I and II are decided by AIC criterion and SC for Model III.


From Table 5 we see that imports Granger cause Zt at 10 per cent level while credit market tightness indicator BR causes the differential at 1 per cent level of significance. Rest of the variables does not have a statistically significant causation.



The evidence in the analysis suggests Indian economy is sparingly integrated with the rest of the world as the value of the covered interest differential is significantly large. We also see that the differential worsened midway the sample period and increased around the time of global financial crisis. We infer that low inflation volatility, strong Rupee and growth in GDP make a more conducive environment for greater financial integration of India with the rest of the world. We see that high macroeconomic stability leads to lessening of the differential, hence more financial integration in the country. Tighter credit market indicated by higher bank rate and higher imports worsen integration in the long run as well as in the short run. Hence stable economy and easier credit market must go a long way in integrating the Indian economy to the world financial markets. (Ma, Ho, & McCauley, 2004)


In order to understand financial integration of a country more comprehensively, one must consider including more segments of the financial market viz. stock, bond market and others. We must however be cautious while interpreting the coefficients of changes in GDP, exports and imports since they use the data of GDP which is interpolated and at best an approximation of real values.



1.     Data on Non-Deliverable Forward and LIBOR is obtained from Bloomberg. MIBOR and Spot exchange rates are sourced from the Database on Indian Economy, Reserve Bank of India.

2.     The data for NEER, real GDP (nominal GDP deflated by WPI) and Inflation volatility has been adjusted have the same base year of 2004-05. Inflation Volatility is calculated as the standard deviation of the GARCH (1,1) of the Wholesale Price Index. Above mentioned variables along with the USD INR exchange rate have been sourced from Database on Indian Economy, Reserve Bank of India.

3.     IIP, credit disbursement by all scheduled commercial banks and L2 measure of liquidity was used to interpolate monthly GDP. The variables have year 2004-05 base and sourced from Handbook of Indian Economy, Reserve Bank of India.

4.     Import and export data are deflated by their respective monthly GDP. The change in each variable implies monthly percentage change of the respective data. The data on VIX is from Chicago Board Options Exchange (CBOE) website.

5.     Full results are not presented in the article to economize the use of words and space.



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Received on 14.06.2019         Modified on 07.07.2019

Accepted on 27.07.2019      ©A&V Publications All right reserved

Res.  J. Humanities and Social Sciences. 2019; 10(3):840-846.

DOI: 10.5958/2321-5828.2019.00138.4