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Lower foreign currency hedging can spell trouble for Indian firms

On Tuesday, before the US Federal Reserve was to start a two-day policy meeting, the rupee gained 0.14%. That gain came after data on Monday showed the trade deficit decreased to $10.8 billion in August, from $12.2 billion in July—the biggest drop in almost a year. Photo: BloombergPremium
On Tuesday, before the US Federal Reserve was to start a two-day policy meeting, the rupee gained 0.14%. That gain came after data on Monday showed the trade deficit decreased to $10.8 billion in August, from $12.2 billion in July—the biggest drop in almost a year. Photo: Bloomberg

Deterred by high cost and RBI's continuing efforts to prop up the rupee, hedging of forex exposures sees a drop

Mumbai: Indian companies are increasingly keeping their foreign currency exposure unhedged, deterred by the high cost of hedging and lulled into complacence by the rupee’s relative stability in recent months.

But a semblance of volatility seems to be returning to the rupee in a warning that such complacency may be imprudent.

On Monday, the rupee lost 0.8% against the dollar and fell as low as 61.17, the weakest since 13 August. On Friday, the currency completed its biggest weekly drop in six weeks on concern that an improving US economy will spur the Federal Reserve to raise interest rates sooner than planned, reducing the allure of emerging market assets.

On Tuesday, before the US Federal Reserve was to start a two-day policy meeting, the rupee gained 0.14%.That gain came after data on Monday showed the trade deficit decreased to $10.8 billion in August, from $12.2 billion in July—the biggest drop in almost a year.

At the same time, one-month implied volatility in the rupee, a gauge of expected moves in the exchange rate used to price options, rose seven basis points, or 0.07 percentage point, to 7.5%.

While exact data for hedging-related activities is unavailable, currency consultants and company executives say hedging of foreign currency exposures has been steadily dropping.

An importer hedging his foreign currency payment obligations would typically execute a contract to buy dollars on a future date at an agreed rate by paying a certain premium to the spot rate. In the case of an exporter, the contract entered into would include an agreement to sell dollars at a future date at an agreed rate. Hedging is typically done by buying or selling currency forwards and options.

In the last one year, the cost of hedging has remained high because of the Reserve Bank of India’s (RBI’s) intervention in both the spot and forward currency markets. The central bank has been intervening in currency markets to stabilize the rupee after it depreciated to a record low of 68.85 a dollar on 28 August 2013.

At the same time, companies have also turned complacent because most expect RBI to continue intervening to keep the currency stable. A stable currency reduces the risk of unforeseen losses. Consequently, companies don’t see much merit in spending on hedging, the cost for which is currently around 8.5% per annum for both currency and interest rate risk.

“I do see conglomerates hedging less," said Prabal Banerjee, president (international finance) at Essar Group. According to Banerjee, before the credit crisis of 2008-09, companies used to hedge about 30% of their exposures, which gradually rose to 45-50%.

However, the hedge ratio may have fallen substantially in the past few months.

“Expectations are building up that the rupee will sustain its strength in the longer run and thus it gives an opportunity to companies to cut down on their hedging cost," he added.

Currency consultants confirm this trend. “A high hedge cost and the range-bound rupee are pushing Indian companies to reduce the hedge ratio on payments. Because of the low business margin and high interest cost, the preference is to avoid an additional burden of hedge cost," said Samir Lodha, managing director of QuantArt Market Solutions Pvt. Ltd, a foreign exchange adviser to companies, adding that his estimate would be that not more than 50% of short-term credit is hedged and only about 25% of long-term external commercial borrowings (ECBs) are hedged.

Lodha said that most Indian companies are assuming that the rupee will not weaken beyond 62-62.50 a dollar due to the build-up in foreign exchange reserves and the strong inflow of capital into India, but he cautioned that a breach of those estimates could spell trouble.

So far this year, the rupee has moved in a narrow band between 60.66 and 61.90 against the dollar. Last year, it moved in a much wider range of 54.68-61.90 against the dollar. To be sure, the relative stability of the rupee has been driven by the fact that foreign investors have bought $14.22 billion in local equities and $18.74 billion in local debt in 2014 so far. In calendar year 2013, they had bought equities worth $20 billion and sold $8 billion in local debt.

“There can be seen a certain complacency on the part of importers. With a stable rupee environment, and strong fundamentals, most of them have drawn a linear projection of an appreciating rupee. There was no need to hedge in the past few months so they have started thinking why pay the forward premia?" said Satyajit Kanjilal, managing director of Forexserve, a currency consultancy firm.

Ironically, the anecdotal evidence of reduced hedging comes at a time when RBI has been pushing banks to ensure that their corporate clients hedge foreign currency risk, which, in extreme situations, can turn into a financial stability risk.

If foreign currency obligations, particularly for importers, are left unhedged, sharp swings in the currency can lead to an increase in payment obligations. This, in turn, can lead to a spike in the demand for foreign exchange and an increased outflow of foreign currency. According to RBI data, the outstanding short-term trade credit in India is $81.7 billion.

Recognizing this risk, RBI has tried to at least insulate banks by asking them to provision against unhedged exposures of their clients. However, the efforts have not yielded much as banks have found it tough to calculate the quantum of such exposures and report them to the central bank.

According to a person familiar with the central bank’s thinking, RBI has also taken up the issue with the Institute of Chartered Accountants of India (ICAI), saying that it should be mandatory for Indian companies to disclose the extent of unhedged exposure in their balance sheets to prevent a possible crisis.

“The Reserve Bank can only regulate the banks and can glean only so much information that a corporate firm voluntarily gives to the banks. RBI has no control over companies and unless you make it a rule to make public the unhedged risks, the actual amount cannot be known," said the person who is aware about the interaction between RBI and ICAI, but did not want to be named.

“The amount (unhedged exposure) could be vast and could be a country risk if a big company defaults on its payments owing to currency fluctuations," the person said.

An email sent to RBI, asking for specifics on unhedged exposure of companies, was unanswered till the time of going to press.

Bankers, on their part, say that while smaller firms listen to banks and hedge adequately, a few big companies prefer to keep a large part of their exposures unhedged, since they feel they can absorb any losses that arise out of currency fluctuations.

“A bank will never give a foreign currency loan unless the corporate firm shows hedges for it, but it is difficult to force them to do hedging for other things. Typically, for shipments arriving in the next six months or so corporate firms hedge, but keep the rest unhedged showing natural hedge and increased projection of exports," said a former chairman of a bank on condition of anonymity.

“Natural hedge" refers to a firm’s earnings in dollars that can be used to pay creditors without incurring any foreign currency conversion cost.

For instance, most steel companies rely on this natural hedge since they export a part of their output and earn in dollars.

Bhushan Steel Ltd said in its annual report for 2013-14 that it has not entered into “any derivatives instruments to hedge foreign currency contracts" as its foreign currency loan obligations are taken care of by exports.

“As against our foreign currency loans obligations, we have exports in the range of 2,000 crore per annum. The exports are expected to increase substantially with ramping up of production. Thus, with exports revenue, there exists the natural hedge against the foreign currency obligations. Further, derivatives have their own cost, and for executing derivatives transaction we need to have limits with the banks," said a Bhushan Steel spokesperson.

“Most of the steel companies rely on a natural hedge—they export 25-30% of their steel production, which helps to offset their currency risk on account of imports of raw materials, namely, coking coal and in some cases iron ore," said V.R. Sharma, group chief executive officer (steel and power) at the Abul Khair Group of Bangladesh.

“The companies that take financial hedge usually do it for their short-term loans such as ECBs, but they almost never hedge their long-term loans," said Sharma, adding that the advantage of a cheaper foreign loan gets negated to some extent when the firms take a hedge on the exposure.

According to currency consultants, while companies are citing the relative stability in the rupee as one reason for cutting back on hedging, such stability cannot be taken for granted especially at a time when markets are anticipating an increase in interest rates in the US.

To be sure, even RBI governor Raghuram Rajan recently cautioned that India “will be tested" by capital outflows once interest rates “start picking up" in industrialized countries.

Some volatility in currency markets is already being seen in response to the dollar, which has strengthened nearly 5.6% since the beginning of July. While the rupee has held steady in July and August, it has slipped 0.2% in September so far.

“Foreign investors would want to be present in the US just before the rates harden. They will most definitely liquidate their holdings here. Even if RBI doesn’t let the rupee fall flat on its face, a gradual depreciation of the rupee cannot be ruled out," said Kanjilal of Forexserve.

Bloomberg and Mint’s Beryl Menezes contributed to this story.

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