Companies leaving forex exposure without hedging; RBI's market interventions to blame?

Wockhardt, once a venerable name in the Indian drug industry, came close to extinction a few years ago. It was not that its business model failed, or that feuding family members were tearing it apart. It was the foreign exchange exposure that it left without hedging which nearly ruined it.

Scores of companies faced a neardeath experience after the credit crisis led to unusual movements in currencies which the wizards of finance had forecast would happen once in many decades, or would be as rare as spotting a ‘Black Swan.’ Something similar may be brewing now.

The relative stability of the rupee in the past year may have helped build Indian businessmen’s confidence, but that has also lulled them into complacency even as they binge on interest rate arbitrage between the local and international markets.

The man who saw the credit crisis coming nearly two years before Lehman Brothers Holdings filed for the world’s biggest bankruptcy, is forecasting a storm in the currency market as the US prepares to end the six-yearlong zero interest rate regime. “Time and again, it does come back,” Reserve Bank of India governor Raghuram Rajan said recently. “It (hedging) is an issue they (companies with foreign debt) should pay attention to. People are getting a little too comfortable with the stability of the rupee.” Even if India’s economic fundamentals are strong with copious foreign exchange reserves and improving fiscal position, when short-term global investors pull out funds due to rising interest rates, currencies could swing wildly as it happened between May and August 2013. That is when companies which owe overseas investors money but have not hedged their exposure, would be whipsawed.

“There should be no surprise that despite recent improvement in sentiments, and some rebuilding of reserves cover this year, India and Indonesia remain the two most vulnerable economies in Asia,” says Taimur Baig, economist at Deutsche Bank. “Both as a share of GDP and reserves, the external funding requirements look onerous.” The rupee has been relatively stable with it appreciating about 0.5% this year after its rout last year, while other currencies are being pummelled. The Russian rouble is down 17%, the South African rand has depreciated 7.4% and Brazilian real has fallen 3.4%. A stable currency also has led to a fall in hedging. The hedge ratio for external commercial borrowings and foreign currency convertible bonds declined sharply to 24% during April-August, 2014, from about 34% last fiscal, RBI data shows. The ratio fell to a low of about 15% in July-August.

Even though Rajan has built foreign exchange reserves, the Indian companies’ external debt has also been ballooning. It has risen to $450.1 billion as of June 2014, from $224.4 billion in 2008. This has to be either repaid either from exports, or through refinancing.

Although interest rate might have made it attractive to borrow in US dollars in the past six years, the exchange rate often spoils the party because it can move violently from the time of borrowing and repayment. To protect against such movements, companies are advised to either buy in forwards or options, otherwise popularly known as hedging. But the question for many borrowers is the cost of hedging. Banks which normally provide such a hedge charge a fee based on their outlook. “That is the risk that the companies are carrying,” says Abhishek Goenka, chief executive at India Forex Advisors. “Being an importdriven economy, there is a currency risk. Hedging cost for principal is high. Companies are reluctant to put up that cost.”RBI data shows. The ratio fell to a low of about 15% in July-August. Even though Rajan has built foreign exchange reserves, the Indian companies’ external debt has also been ballooning. It has risen to $450.1 billion as of June 2014, from $224.4 billion in 2008. This has to be either repaid either from exports, or through refinancing.



Although interest rate might have made it attractive to borrow in US dollars in the past six years, the exchange rate often spoils the party because it can move violently from the time of borrowing and repayment. To protect against such movements, companies are advised to either buy in forwards or options, otherwise popularly known as hedging. But the question for many borrowers is the cost of hedging. Banks which normally provide such a hedge charge a fee based on their outlook. “That is the risk that the companies are carrying,” says Abhishek Goenka, chief executive at India Forex Advisors. “Being an importdriven economy, there is a currency risk. Hedging cost for principal is high. Companies are reluctant to put up that cost.”

Gross external financing = residual maturity debt (due in the next 1 year) + projected current account balance The cost of hedging is at about 8% to 8.5%, and this has risen from about 5% a few years ago. If one factors in the hedging costs to borrowing, it is about 10% for a top-rated company, which erodes the cost advantage that it gets from borrowing overseas.

This has forced many to abandon hedging in a climate of calm. Why is the cost of hedging so high that it inconveniences companies? Part of the problem lies at the doors of the Reserve Bank of India, which wants to ensure that it does not release much rupee into the system by buying the USD inflows from foreign institutional investors. Its anti-inflation stance forces it to buy US dollars in the forward markets, pushing up the forward premium. If it buys in the spot market, it could flood the market with rupees and push down interest rates, the opposite of what it wants. “You are doing forwards since you do not want to have liquidity in the system,” says a currency trader at an international bank in Mumbai who did not want to be identified.

“That is keeping the forward premium high deterring companies from hedging.” The central bank has bought $37.2 billion in the forwards market since April, data from the RBI shows. Reserves increased by around $40.3 billion in the past one year to around $316 billion. There may be a mountain of US dollars lying in RBI vaults, but Rajan is firm, at least for now, that he will not save reckless companies by intervening to protect a level for the currency. “We will prevent undue volatility,” said Rajan. “Undue volatility doesn’t mean no volatility. I don’t think anybody should therefore presume it is okay not to hedge exposures and the RBI will bail them out.”

The governor’s tough stance, the forecast of rupee at 70 to the US dollar and companies’ reluctance could spell trouble for banks. Since there is no one regulating companies’ currency trading, RBI put this burden on banks. Banks were directed to set aside more funds if their clients have unhedged foreign exchange positions. “Banks now have to make a provision for unhedged exposure of their clients,” says Kuntal Sur, partner, KPMG. “Banks are huffing and puffing.

Getting the information is a nightmare With the US economic recovery getting stronger and unemployment rate falling, the Federal Reserve is expected to raise interest rates earlier than expected — may be mid-next year. The Indian economy may be in better shape than what it was when former Fed chairman Ben Bernanke talked about tapering bond purchases which jolted the currency into record lows, but that is no insurance when it comes to the rupee movement.

History shows that countries can be troubled by currency movements despite strong economies as it happened to Mexico during the so-called ‘Tequila episode’ in the 90s. India may be no exception, and the companies may be repeating their mistake if they believe they are masters in predicting currency movements.

“In financial markets, there is nothing called a free lunch,” says Goenka of India Forex Advisors. “In the past four to five years you have been having free lunches. Now may be the time to pay.”