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Challenges of a depreciating rupee

G. KARTHIKEYAN
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G. Karthikeyan
G. Karthikeyan

Abhilash Gupta is an exporter of yarn and he has reasons to be extremely delighted these days in view of the increasing dollar value and huge export orders on hand. The Government, too, has stepped in with efforts to boost the sagging export sector with Rs 1,200 crore in sops and interest subvention measures, especially in the light of the demand slowdown in the Euro Zone and the US.

Following the steep dip and the expectation that the rupee will fluctuate drastically based on global trends and the Euro-Zone crisis, Abhilash’s banker advised him to hedge his receivables at 56.25 to ensure the best yield against a fluctuating rupee. While taking into account his banker’s advice, Abhilash was also reminded of a bitter hedging experience a few years ago, which made him wary of hedging.

Terms

However, before venturing into details, let us first look at some of the terms which may be foreign to all those who do not normally operate in the forex market.

A “hedge” technically speaking is an investment position which offsets losses incurred by a companion investment. In the forex market, hedging is used to eliminate risk resulting from transactions in foreign currencies.

A forward contract is a hedging device which fixes forex rates for the future. In essence, a forward contract is a non-standardised contract between two parties to buy or sell an asset in the future at a price agreed upon in the present.

Another frequently used term is arbitrage. Arbitrage is the practice of taking advantage of price differentials in two markets so that buying in one and selling in another yields an overall profit.

Now, to come back to our case for hedging and Abhilash’s experience — bankers of course promote hedging as a zero-cost and zero-risk activity. Such, however, is not the case.

Let us look at some situations: let us assume that Abhilash as advised by his banker books a forward at Rs 56.25. Now a month later, when he delivers the contract, he will settle it 56.25 for a dollar. However, if the prevailing exchange rate then is 60 to a dollar, Abhilash stands to lose. Bankers will, of course, argue that the loss is notional but we need to look at certain related factors.

Abhilash’s business is trading, not manufacturing. Margins are already as low as 3 per cent. Competition is cut-throat. If a competitor can sell to the same customer at 60 to a dollar, he will have an edge and a better margin. The forward in this case would not work to Abhilash’s advantage — he stands to lose clients as well as a higher margin.

To quote Abhilash’s actual experience — he once saw other trading companies sell forward positions in bulk, took a cue from them and sold his position as well. What Abhilash did not realise was that the other companies were doing this as part of an arbitrage activity.

They already held positions in other international markets and hence their risk was covered — the price differential would actually yield a profit while Abhilash held a position only in the Indian market and stood to lose.

Better for manufacturing

To look at some more facts — hedging and forward contracts work better in the manufacturing sector because the margins are higher and therefore the appetite for risk is higher. The ability to withstand a loss is also considerably stronger when compared with traders. Having said that, adverse situations develop in manufacturing too. For example, an exporter of hosiery receives an order and based on that books a forward.

One must of course note here that typically western importers would place orders for winter wear well in advance so that the goods hit the market in November at least. Assuming the order is placed in late September and the forward contract is booked accordingly by the exporter, what would happen if the rupee depreciated further and the local raw material supplier increases yarn prices as well?

In this case the exporter must take a double hit. On the one hand he is sitting on a hedge and therefore his yield from the deal is fixed. He cannot take advantage of the forex situation.

On the other hand, he must also pay a higher price for the yarn. The buyers abroad are also aware of currency fluctuations and the resultant advantage enjoyed by the exporter. As a result they request appropriate price discounts but there may not be any upward revision on a later day when the dollar is weak.

The above analysis brings out some of the aspects of hedging that many exporters tend to ignore. Hedging is a must as protection from risk but it would probably be better to hedge a part of the receivables and leave some open to risk with the proportion being decided by one’s appetite for risk.

One must also add that hedging is for experts — those who can study forex trends and predict currency fluctuations correctly. Moreover, as most exporters are in small businesses, specialised treasury advice services are an added cost. Even in such cases the risk is high. A quarterly interpolated forecast from an international bank in November placed the rupee at close to 47.50 against a dollar in June, whereas we are closer to 56 today.

Forecasters and meteorologists probably belong to the group of experts who will know tomorrow why things predicted yesterday did not happen today. The fact remains that hedging and arbitrage is not the core competency of exporters or traders such as Abhilash. Their skills lie elsewhere and trying to make a business out of forex activities could only serve to take away core time and profits.

(The author is a Coimbatore-based chartered accountant and can be reached at karthi@gkmtax.com

(This article was published on June 22, 2012)
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Comments:

interesting and educative

from:  Sulur Theivannan Seshagiri
Posted on: Jun 24, 2012 at 07:57 IST

Interesting article and an eye opener especially for the trading sector who should look to making profits on an order-wise basis rather than a pool. You have conspicuously avoided any reference to options. This is a better hedging option for traders who need not exercise the option on the due date in case of an adverse movement of the foreign currency. The only loss which can always be treated as business expenditure is the option premium which has to be paid upfront unlike a forward contract where it is mandatory to fulfill the contract on the due date. This may also be highlighted.

from:  nagesh pydah
Posted on: Jun 25, 2012 at 05:50 IST
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