Significant forex-related items showing up in the quarterly disclosures to investors would change the incentive structure away from taking no action, to actively managing currency risks.

India Inc has been vociferous in blaming ‘policy paralysis’ for everything from fluctuating profits to the negligible investments in new projects. True, the Government has been ultra cautious in its decision-making, given the fragile nature of the current coalition arrangement. Yet, Indian companies, too, have been giving a successful imitation of a deer caught in the headlights, when it comes to handling a volatile business environment. Whether it is commodity price volatility or exchange rate movements, they have preferred a policy of frozen inaction to a proactive one of hedging against such risks. As the Reserve Bank of India (RBI) Executive Director, G Padmanabhan noted only the other day, higher volatility in the rupee’s exchange rate is the ‘new normal’ in the current uncertain global environment.

The financials of listed companies point to their being major foreign exchange users, with over three-fourths of them exposed to currency risk in some form or another. Yet, they seem to fall into two extremes. While some of them have lost heavily from aggressive exposure to derivative contracts, the vast majority have chosen to simply keep large foreign exchange loans or imported input costs un-hedged. The explanations offered are, at first sight, not without merit. Companies claim not to understand the derivative markets enough to feel confident of taking exposures on their own. Also, since they are in no position to judge the direction of the rupee, they wouldn’t want to be pulled up by shareholders for losses on their forex positions. Nor – especially after the fiasco with textile exporters a few years ago – are they convinced about the quality of advice from banks structuring contracts in the over-the-counter market. And finally, the cost of hedging itself is high.

On a closer scrutiny, however, there are effective counter-arguments as well. While taking a derivative exposure in currencies, a company’s primary aim should be to ensure that the exchange rates are in accord with their business plans, rather than an opportunity for making windfall gains from a particular position. Viewed from this perspective, the company is not betting on the future direction of movement of the rupee. A software firm going ‘long’ on the rupee-dollar futures at Rs 55 isn’t really speculating on the future movement in the currency market, if its business plans had assumed revenues from its offshore clients to be flowing at that exchange rate. Ditto with input costs payable in foreign currency. There is a market failure situation now warranting official intervention. The Government should remove the incentive available to corporates for not having to mark their losses to the prevailing market rate if they had not hedged their exposures, as opposed to a ‘mark-to-market’ requirement in the case of hedged exposures. That move alone – significant forex-related items showing up in the quarterly disclosures to investors – would change the incentive structure away from taking no action, to actively managing currency risks.

(This article was published on August 2, 2012)
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