The Hindu Business Line : Forex derivatives and ‘Armstrong’ Palanisamys

Knitwear exports from Tirupur have grown from Rs 15 crore in 1985 to over Rs 10,000 crore now — a stupendous feat achieved by home-grown entrepreneurs, through competitive churning within. But the fall of the dollar saw a downturn in their fortunes that has been exacerbated by losses suffered from complex forex derivatives, says S. GURUMURTHY.

The prospect held out by bankers was music to the ears of the desperate exporters. But all that multiplied were their woes.

The novel-like prologue is inevitable. ‘Armstrong’ Palanisamy is a typical home-grown entrepreneur in the global knitwear hub of Tirupur. A farmer’s child, he was on the field and also at school, more in that order.

But, like many in Tirupur then, he too failed in his Pre-University Course. In the mid-1960s, he joined a knitwear unit in Tirupur. Like for most, for him too, it was an open-air MBA course in the knitwear business.

Soon, like his peers, he started his own knitwear work. At that time Neil Armstrong had landed on the moon. His name was on everyone’s lips, including in Tirupur.

Armstrong brand

So, the new entrepreneur, keen to penetrate the US market, branded his banians and T-Shirts as ‘Armstrong’. And, soon, he himself soon got branded, after his product, ‘Armstrong Palanisamy’. But he is no anecdote. He is a sample of the now globally-known Tirupur entrepreneurs.

Hundreds like him, big and small, had sprung up in Tirupur in just two decades. Dr Sharad Chari, in his meticulous research titled Fraternal Capital: peasant-workers, self-made men and globalisation in provincial India (Stanford University Press), traces how most entrepreneurs of Tirupur belong to one community — Kongu Goundar.

The science of their massive progress as a group is this: contagious competitive spirit forced one to copy, compete with, others within the community, turned into a sociological mix of business rivalry and fraternal co-operation that triggered an exponential entrepreneur development model in Tirupur. This is a subject in itself.

‘Social capital’

This is how the Tirupur entrepreneurs evolved: from cotton farming to cotton ginning, ginning to spinning, spinning to knitting and finally as knitwear exporters, soon to became a global brand.

The World Bank took the Goundar community by name in the World Development Report 2001 and noted its rise as a global knitwear force by leveraging on its own internal strengths as a community — read ‘social capital’ — often derided as caste.

The Bank also discovered how the Goundars had relied on their traditional networks, not on modern banks, to circulate their savings within to find and fund the capital they needed.

The Goundars graduated as entrepreneurs, not from IIMs, but by the contagious competitive churning within.

Sharad Chari’s painstaking work points out that two-thirds of the knitwear makers, like Armstrong Palanisamy, are matriculates or less, with only a third having been to college, and none — yes none — professionally qualified, thus pointing to the inverse relation between education and entrepreneurship.

Export growth

Knitwear exports from Tirupur have grown from Rs 15 crore in 1985 to over Rs 10,000 crore now! The liberalisation of the forex sector and the zeal to depreciate the rupee to make exports cheaper, saw the dollar appreciate and the rupee fall, by some 450 per cent in a decade. This put Tirupur on a growth escalator.

Knitwear exports from Tirupur rose as the dollar strengthened against the rupee from some Rs 13 to a dollar in 1991 to some Rs 50 in 2002-03. Subsequently, the dollar began slipping against all currencies and also, but less, against the rupee, thanks to the RBI’s policy to keep the rupee cheaper.

In the early months of 2007, the dollar was ruling at some Rs 44. Till then everything was going well for Tirupur exporters. But the history reversed from April 2007 onwards. A dollar of export, that fetched Rs 44 in March 2007, slipped to almost Rs 40 in just four months. The exporters lost thus.

If, in March 2007, an exporter had contracted to deliver 1,00,000 T-Shirts at $5 a piece in June 2007, his export bill would be $500,000, which at Rs 44 a dollar would get him Rs 2.20 crore on delivery. But as the dollar had fallen to Rs 40 by June, he would get less, only Rs 2 crore! With the annual exports in Tirupur being $2.2 billion, at any given time the knitwear under delivery or pending for payment would be more than $750 million, or Rs 3,300 crore.

If the dollar fell from Rs 45 to Rs 40, their loss would be Rs 300 crore. And expecting that the dollar would go up, not come down, many had kept the sale income already received in dollar account which also depreciated when the dollar collapsed in April-June 2007. The estimated loss of Tirupur exporters due to the dollar fall was estimated at Rs 400 crore.

Forex derivatives

Now begins the story. When the Tirupur exporters stood perplexed by the sudden and unexpected, adverse turn of events, a set of banks, most of them the new class of private banks, sent their most articulate and modern forex derivative salesmen to the simple-minded exporters. They unveiled before them a magic safety net.

They counselled the knitwear exporters not to think that they could make money only by exporting knitwear — a hard task — and told them that they could earn more, and easily, by playing in the forex market through derivative products. They assured them that the income they earn by buying and selling the forex derivative products would more than compensate them for their losses due to the dollar fall. These banks did not confine themselves to Tirupur. They went to every such community-led industrial cluster — Ludhiana, Surat, Rajkot, Baroda, Coimbatore, Tirupur, Karur.... But this story is about Tirupur.

The exciting prospect held out by the enterprising bankers was music to the ears of the desperate exporters. The banks had also told them that the derivative products had been devised by Nobel Prize winning economists! For the Armstrong Palanisamys of Tirupur reeling under the pain of the dollar fall, it was too tempting a relief. What is a forex derivative?

Stated in less complex terms, the forex derivatives marketed in Tirupur are a bet like any other bet. Here the bet is about whether the euro or yen or Swiss franc or French franc would rise or fall against one another and/or against the dollar and by what margin they will do so. If the bet goes right the exporters gain; if it goes wrong, they lose. The best financial brains cannot predict who would win the bet or lose.

Says www.finpipe.com , a Web site dedicated to promote knowledge of derivatives: “Politicians, senior executives, regulators and even portfolio managers have limited knowledge of these complex products.”

Buffet-speak

This is not in Tirupur or Ludhiana but in the West where derivative products are traded like bananas. Yet, Warren Buffet, the world’s richest and also the most accomplished financial brain, fears derivatives as financial WMDs, that is, weapons of mass destruction.

Some derivatives, says Warren Buffet, seem to have been devised by ‘madmen’. If Buffet is scared of derivatives and sees them as madmen’s game what would the exporters of Tirupur, who are ex-farmers, and two-thirds of whom are matriculates and less, know of derivatives, is obvious.

Even as the banks sold complex currency derivative products — feared by Warren Buffet as WMDs — to Armstrong Palanisamys, they knew that the uninformed buyers of their new wares were unaware of the consequences of playing with the new, enchanting toys.

The alluring assurances by banks persuaded the Tirupur exporters, given to herd mentality, en masse to sign up and buy the magic derivative products running into hundreds of millions of dollars, which they were told, and they believed, would relieve them of their sudden losses.

In the first few derivative dealings, the derivative merchants did manage to credit some profits to the exporters, which lured them even more to the new toys. Thus, from April 2007, the slick merchants of derivatives sold hundreds of millions of derivative-wares in dollars, euros, pounds, Swiss francs, Japanese yen paired in different mixes.

Increased risk

These derivatives were not devised to hedge the exporters’ risk, but to yield profits to them. And, therefore, they increased the exporters’ risks and exposed them to losses that were multiples of the losses occasioned by fall in the dollar value. Take the case of Armstrong Palanisamy. By about March 2008, the banks began asking him to pay — believe it! — over Rs 30 crore as loss on the derivative products sold to him on which he was, at the start, assured of adequate profit to offset his loss of some Rs 3 crore on dollar fall!

Thus the derivatives multiplied his woes. Most exporters of Tirupur suffered Armstrong Palanisamy’s fate, with some hit by more, and some by less, losses. The derivative loss of Tirupur is estimated at Rs 500 crore. This is in addition to their loss due to the dollar fall. Now comes, the next part, the story of how the derivatives that are intended to protect turned destructive to Tirupur.

(To be concluded)

(The author is a corporate advisor. His e-mail is guru@gurumurthy.net)