Forex markets — Ease corporate hedging limits

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Volatile markets demand that companies set up rigorous stop-loss limits on their forex positions.
Volatile markets demand that companies set up rigorous stop-loss limits on their forex positions.

In this new world of increased volatility, corporate forex risk managers should not hope for significant macroeconomic policy changes. Instead, they should pitch for increased operational flexibility.

The President of the FIEO and the TEA (Tirupur Exporters' Association) recently exhorted the Government and the RBI to peg the dollar/rupee rate at 47 in order to aid the exports recovery. The industry body cited how China has been steadfast in maintaining the yuan at 6.82 to the dollar to support its export industries (despite increasingly vociferous calls from across the world for a (gradual) dismantling of this peg).

It is not difficult to understand the garment export sector's predicament here. Indeed, with input costs spiralling out of control (courtesy high local inflation — witness the sparring over yarn prices in recent months), a competitive exchange rate could be a crucial aid for the export sector.

At a more technical and operational level also, the industry's plea is understandable. Indeed, with volatile two way moves in the rupee becoming increasingly common — a 50 or 60 paise move (that is, a move of 1 to 1.5 per cent) in a day — effective corporate forex risk management is also rendered increasingly difficult. Wrong calls and opportunity losses on currency moves are now the order of the day in day-to-day corporate financial risk management. It is a thankless job for the financial risk manager in these circumstances — since the top management and the outside world do not easily (understand) accept that opportunity losses are a price to be paid when a hedging programme is instituted. (People in fact talk about losses in hedging when actually the hedging action is designed to fix prices or costs).

Moreover, accounting rules also reflect forex opportunity losses in the financial statements. More importantly, note that when you are working on a 7 or 8 per cent profit margin, a 1.5 per cent adverse move wipes out close to 20 per cent of your profits.

Pegged rupee?

A pegged rupee though seems an unrealistic expectation. Though there is a long history of the RBI actively managing the rupee (and also generally preferring a weak rupee), a de jure peg could be a different ball game for which the Government and the RBI may not be prepared. (We have said de jure here since the official policy of “managing the impossible trinity” goes some way in creating a de facto pegging regime in India).

A managed rupee exchange rate regime with a fair degree of volatile movements seems set to continue for the foreseeable future. In this world, we will see the RBI continuing to actively manage the rupee and slow down its structural appreciation — that is, allow only controlled appreciation.

Companies must also budget for sudden upsurges (appreciation) in the rupee like in the second quarter of 2007. Opportunity losses may also be severe when risk aversion induced capital (out)flows depress the Indian markets — like in the post-Lehman period in late 2008 and now in the past few weeks.

In other words, in this new world of increased volatility, corporate forex risk managers should not hope for significant macroeconomic policy changes such as a change in the exchange rate regime itself. They, instead, should pitch for increased operational flexibility when it comes to forex risk management.

Hedging limits

In this context, one wonders whether the extant forex risk hedging limits permitted for companies are really sufficient.

The RBI currently permits hedging limits equivalent to a company's previous three years' average exports/imports or the previous year's export/import, whichever is higher.

Companies can have these limits set up based on their past performance. In other words, these limits should be available from Day 1 of a financial year even as the exports (or imports) take place through the year. For instance, if a company does exports of $24 million in a year, it should have limits of $24 million.

At a practical level, we have seen that commercial banks in many cases do not provide companies with the full limits permitted by the RBI itself. (The response usually is that the companies have not asked for the same!).

Going beyond this procedural issue, the RBI should note that it may be difficult to practice dynamic risk management with the limits cap it imposes.

Volatile and unpredictable markets demand that companies set up rigorous stop-loss limits on their forex positions. This is a basic step in forex risk management (or more generally in financial risk management) to limit opportunity losses and being able to take advantage of dynamic market movements.

In today's markets environment, implementing rigorous stop-loss rules may mean that a company has to enter and exit forex positions many times even in a month. But the limits cap which the RBI places would precisely prevent such dynamic risk management. The cap is like asking companies to fight a battle with tied hands.

(The author is Vice-President(Economic Research), ShriramGroup Companies, Chennai. Theviews are personal.)

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(This article was published in the Business Line print edition dated June 16, 2010)
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