It is in the third scenario that the company loses money on the deal. It has to buy dollars at 1.33 to a franc from the bank, when the market rate is far lower. But, as we said earlier, the Swiss franc seemed unlikely to touch that rate against the dollar when the deal was signed at the end of June 2007, since it had moved in a tight corridor in previous months.
But the Swiss currency did leap outside this corridor against the dollar, as the US greenback fell after the US Federal Reserve slashed interest rates and the world’s largest economy headed into a recession.
The sudden drop in the value of the US dollar did not surprise economists who had been predicting this for quite some time. But the financial markets had taken a very sanguine view about the scars in the US economy—a huge fiscal deficit, a growing trade gap, a housing bubble and lax lending standards in the financial system. The drop in the dollar singed many investors, including Indian companies that had bet on its stability by looking at the recent past.
There were similar unexpected movements in other asset markets, including the price of emerging market bonds. Another sort of price tumble—of emerging market bonds—hit ICICI Bank which announced mark-to-market losses of 264 million on credit derivatives in early March.
Financial turbulence led to a global sell-off on all sorts of assets that have higher risk, such as bonds issued by companies in India. The credit derivatives that are based on them also saw price declines.
“Until August, there was no real widening of spread and so, there was no erosion in the market value of the portfolio. In the September quarter, the spreads widened and we first booked losses. We are aware of our portfolio and every quarter we need to follow the accounting practice of marking to market. It will all depend on the spread,” ICICI Bank joint managing director Chanda Kochhar told Mint in early March.
How serious is the problem?
No doubt about it: The raw numbers seem mind-boggling. But what do these numbers really tell us about the risk to the Indian financial system?
Ever since finance minister P. Chidambaram told Parliament that banks in India had a total derivatives exposure of Rs127.86 trillion, there have been concerns that there is an unlit derivatives bomb in bank balance sheets. After all, the derivatives held by banks are more than three times India’s trillion dollar gross domestic product (GDP).
“The financial sector as a whole has evolved a lot and the banking industry is coming up with newer and newer instruments which are complex. Unfortunately, regulators have not kept pace with the developments happening. The gulf between players introducing ever newer and more complex instruments and the regulators is widening to the disadvantage of the public,” says Rajeev Chandrasekhar, the member of Parliament who asked the parliamentary question that Chidambaram replied to.