Mumbai: The beginnings of India’s controversial derivatives muddle can be traced back to a period of extraordinary and beguiling calm in the global financial markets. But it was actually the calm before a storm that has sunk many ships.
The International Monetary Fund (IMF) had noted in the April 2006 edition of its Global Financial Stability Report: “Low nominal and real interest rates and the environment of low volatility…has continued to encourage risk-taking and leverage.” A four-year global economic boom that was aided by low borrowing costs had lulled bankers, investors and company treasurers around the world into believing thata few extra risks would do no harm.
Data collected by the Bank of International Settlements (BIS), a central bankers’ club based in the Swiss town of Basel, shows that the size of the global derivatives market more than doubled between 2004 and 2007, to touch $516 trillion. India, too, saw explosive growth.
How Hedges Became Messy (Graphic)
Dramatic Growth (Graphic)
There was another factor at play in India. The sharp rise in the rupee after April 2007 had eaten into the profits of many small exporters. “Exporters tried to protect their earnings by going in for exotic foreign exchange derivatives,” says veteran financial consultant A.V. Rajwade. “To my mind there was a lot of mis-selling and gross transgressions of RBI (Reserve Bank of India) regulations,” he adds.
The subprime crisis had already reared its ugly head in the US mortgage markets. But the overall outlook appeared sanguine. So it seemed safe to make all sorts of risky derivative bets.
And then a lot of things went horribly wrong. The credit crisis struck in August. By the end of the year, large parts of the Western financial markets were shut for business, central banks were doing stuff they had never done before to save embattled financiers, and currencies, bonds and equities were bouncing off in completely unexpected directions.
Twelve months later, in April, many Indian companies and banks are battling each other in the courts to decide whether various derivative deals are within the law. The Institute of Chartered Accountants of India (Icai) has asked its members to ensure that the firms they audit keep aside money for potential derivative losses. And informal estimates of how much money Indian companies could lose in case they sold their derivatives right away—what accountants call mark-to-market losses—have climbed to Rs20,000 crore.
So, what went wrong?
The second half of 2007 was not a replica of the first half.
An imperfect guide