The author explains how Indian companies are avoiding hedging costs at the cost of dollar appreciation
04-Sep-2015 •Sanjeev Pandiya
Forex reserves are at a record high, while hedging levels are at a record low. The good job that Raghuram Rajan has done by managing rupee levels has led to complacence that this will continue. Even as the RBI rues the low hedging levels of nearly 15 per cent, India Inc switches off the radio and sleeps at the wheel. The result of this indiscipline is that the RBI has to be shoring up the dollar and keeping excess reserves to protect itself against a run on the rupee.
The RBI has been putting pressure on banks to ensure that Indian corporates are hedged against rupee depreciation, but these hedging costs will bring the cost of forex loans at par with the cost of domestic borrowing. So, corporates are tempted to skimp on hedging costs and stay open to the risk of dollar appreciation, hoping that everything will work out all right. Where have we seen that before?
It's OK to break your leg, but don't break your neck. Some risks are acceptable, but others are not, as our fathers told us. Then why do we do such risky things again and again, and why don't we learn from past mistakes? Our uncovered forex exposure of $70 billion will force the RBI to hold reserves in excess of reasonable needs, thus incurring a cost. The return from US Treasuries is 2.5 per cent, while the opportunity cost would be, say, the India GOI bond rate of 8 per cent. This huge notional loss is being borne by the country to hedge against the private indiscipline of India Inc.
Why doesn't the RBI simply mandate a high hedge ratio, thereby creating a steep forward curve, and tell corporates to manage their hedging costs as best as they can? If people defecate out in the open, their private indiscretion creates a public cost in the form of higher sanitation cost, public-health risk and the cost of cleaning the city. This comes back to the public in some way, just that the people who defecate don't really pay the full cost.
It is the same with hedging costs. India Inc. defecates out in the open, with some sectors more to blame than others. Low-margin traders, like edible oils, tend to build big forex exposures, which come to grief during a 'flight to safety'. These are the panicky importers who created the last spike in the dollar-rupee exchange rate from 64 to 68 rupees to a dollar in the taper tantrum of mid-2013. The collateral damage on the rest of the economy (and maybe the Congress Party) is well known.
If hedging of long-term forex loans were made mandatory, the interest rate arbitrage would disappear, and people would go back to domestic borrowing, creating demand for domestic credit, which has been sluggish. For example, if the edible-oil industry were forced to hedge all its imports, this would raise the landed cost of imported oils, making domestic edible oils more competitive. This would correct the mispricing of imports, which is a good thing all round.
Corporates should be forced to manage their cost of hedging on domestic currency exchanges, which would widen and deepen Indian currency exchanges, a spin-off benefit. The market-wide impact of introducing this cost would reduce the possibility of a currency crisis by forcing importers to depend on domestic borrowings. Exporters, on the other hand, would not be affected. At least the spate of corporate bankruptcies that follows each big spike in the dollar-rupee exchange rate would be avoided.
Take the case of the edible-oil industry. Operating margins are 3 per cent, while hedging costs are around 7 per cent. The industry is fragmented, so if any particular player were to hedge its forex exposures, it would be driven out of business. So nobody hedges, leaving the entire industry open to the risk of a sudden spike in the dollar. The only way to survive in this industry is to look for, and be able to have, no imports in the pipeline when the disaster (i.e., currency crisis) strikes. As one promoter famously told me, "I have to choose between dying today versus dying tomorrow."
So is it right to say that the entire bank lending to the edible-oil sector is actually dead, and that banks are booking false interest income from this sector to be written off at some future date? If hedging were made compulsory, the cost curve of the entire industry would shift upward and prices would reflect the correct cost (which includes the cost of hedging forex). That would save everyone, including the industry and the banks that lend to it.
Why are industries that have domestic sales in rupee allowed to borrow in forex at all? Isn't that a recipe for disaster? Shouldn't there be a clear directive to banks that net importers should not be allowed forex borrowings? If all importers are hedged, there will be no currency crisis because a lot of import demand would turn to domestic sources, thereby reducing the current account deficit and foreign commercial credit. This would increase the domestic corporate credit demand and give incentives to domestic savers to fund that incremental demand. As a corollary, this would reduce the RBI's cost of holding excess forex reserves.
A culture of interest-cost management should be promoted just the way commodities are listed to enable producers and consumers to hedge their requirements. The simple but dangerous choice, which all lesser human beings are prone to taking, is to take on forex risk to book some (interest) cost savings. This has always proved counterproductive in the long run, creating vast economic damage to the larger economy.
Can you ban defecation in the open and put people in jail? I don't think so. You have to create cleaner options and use education and information to promote good behaviour. Just like defecation in the open (and risky sexual behaviour) is to be found more among the poor and the ignorant, here too it is SMEs and small businesses which are most prone to taking excess forex risk. To discipline them, you need to tell banks that foreign borrowings are restricted to those who show demonstrated ability to manage forex risk.
This brings us to the banking system to monitor all this. I find that frontline PSU bank officers know less about forex than they know about banking, so these assessments should be centralised with the credit-risk cells at the central office. And no forex loans (PCFC or ECB) should be disbursed until there is a clear certificate from the credit-risk department that the borrower is capable of looking after himself.
For those who remember, the structured-derivatives scam (of circa 2008) was about private banks loading invisible forex risk onto corporate balance sheets to book huge Treasury profits on their own books. The policeman turned rapist, and some banks got a huge rap on their knuckles for this. If instead, these same banks were given the mandate to sell interest-cost reduction structures for domestic borrowers, they would end up taking on the forex risk on themselves. As domestic companies reduce risk, some banks might find it profitable to take forex risk onto themselves, creating quite a profitable niche for their bottom lines.
But socialisation of the costs of private vice should be managed. This happens in many places, Greece being a good example, but when it affects a country's macro stability and the relative wealth of its population, it is a very big hidden cost that must be brought to public consciousness. The higher risk premium attached to higher volatility holds back foreign equity investment, leads to higher borrowing cost in the international market and reduces the stature of the currency and country.
One look at Switzerland and you can see how a currency can build a country. Whether it is a safe haven or a city financial centre (Singapore or Hong Kong), you will find that these countries reap huge benefits by installing the rules of good behaviour in their country's social fabric. Without aspiring to similar status, a large country like India can hardly afford to allow such risky behaviour. At the other extreme, Russia has shown that even a large country can be brought down to its knees by promoting cronyism, another pattern of bad behaviour where private vice has caused public disaster.
The author teaches, trades and writes at spandiya.blogspot.com.
This column appeared in the August 2015 Issue of Wealth Insight.