It is difficult to see how corporates can price their products correctly with uncertainty on forex costs.

It is, perhaps, unrealistic to expect any market to consist solely of players in genuine need of a commodity and an army of willing sellers with the wherewithal to fulfil that requirement. For, there will always also be players who only have a view on the future price of that commodity, and are willing to back up that judgment with their own money on the line. Unfortunately, India’s forex market has the worst of both the worlds. Not only do people with bonafide exposure to currency volatility prefer not to proactively hedge such positions; the market also consists of dealers who can dump their losses from incorrect reading of future price movements on to genuine customers wanting foreign exchange to be delivered on the spot. Clearly, this has to change. The first step here would be to get players with genuine exposure to volatile currency movements to come in and hedge their risks.

The Reserve Bank of India’s (RBI) latest directive, asking banks to charge a higher risk premium on loans made to corporates who haven’t hedged their exposures to forex fluctuations should be seen in the above light. More than half of Indian companies’ foreign currency exposures today are totally un-hedged. It is difficult to see how corporates can price their products correctly, so as to ensure a desired level of profitability, if they face uncertainties on their forex-related costs. For banks, the best guarantee of repayment of the monies that they have lent to an enterprise is for the latter to be operating profitably. Once banks, forced by the latest diktat, start jacking up the interest and fees charged to companies with large un-hedged forex exposure, the latter may understand the worth of incurring additional costs of hedging just in order to keep their finances healthy. The RBI has, in fact, instructed banks to put in place proper systems for risk evaluation of clients’ forex exposures before this calendar year-end.

At the same time, the direction to banks to fix limits on the un-hedged position of corporates, based on policies approved by their respective boards, amounts to excessive micro-regulation. Hedging, after all, is an optional act. It is for individual companies to determine whether to buy safety through hedging contracts, or pay more interest on their loans as and when banks start charging a risk premium against their unhedged exposures. Even if banks were to decide on the limits of un-hedged positions of their clients, these would need to be made sufficiently flexible to accompany the varying conditions and requirements of borrowers. The RBI also needs to do address the problem of opacity in the inter-bank foreign exchange market, so that there is a clear demarcation of trades on clients’ (customers) accounts and those entered into as the bank’s own proprietary positions, similar to that observed in equity markets.

(This article was published on November 1, 2012)
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