When forex losses bleed exporters

In recent years, the UK subsidiary of Tata Motors (TM), JLR (or Jaguar Land Rover), has accounted for as much as 90 per cent of the parent company’s profits. Therefore, it was no surprise when for the December 2016 quarter, a steep 60 per cent decline in JLR’s net profits led to a 95 per cent fall in TM’s net profits.

New launch costs, higher marketing expenses, wage settlements and large forex losses arising from a sharply weaker pound sterling were cited as key reasons for the decline in profits.

With respect to large forex hedging losses, we need to understand:

What has caused these large losses

What lessons other Indian companies, with multinational operations and financial linkages, can draw from the TM developments

How they can try to avoid or at least minimise such large forex losses in their operations.

The TM experience and the lessons from it would be relevant not only for large and complex companies. They are pertinent even for our much smaller garment exporters from Tirupur or Ludhiana — who export to the UK or the Euro Zone — and thereby take on significant currency risk in their operations, whether they invoice their sales in the pound, the euro or the US dollar. When large swings in financial markets are the norm, currency risk becomes a bigger challenge in whatever currency a company invoices its exports or imports. Hence, the need for an enhanced technical approach in FX risk management to avoid/minimise losses.

How the loss occurred As for the large forex losses of TM, immediately following the Brexit results in late June 2016, the pound fell from nearly $1.50 to $1.27 levels. It has then weakened further to $1.23/$1.24 levels as the chart shows. That is, looked at from a US dollar invoicing perspective, each dollar was fetching nearly 20 per cent more pounds by end 2016 compared to mid-2016. More than 80 per cent of JLR sales comes from outside the UK — and more critically — they seem to be invoiced in US dollars.

More than the invoicing currency, it is the choice of the hedge instrument for converting its export sales that seems to be generating losses for the company.

The company appears to have sold (through the conventional forward contract) its US dollar receivables based on a spot base-exchange rate of around $1.50 to the pound. With negligible interest rate differentials, the forward sale rates would have been quite close to the spot base rate of $1.50.

Therefore, JLR was converting its US dollar receivables into pounds at the vastly disadvantageous rates of around $1.50 per pound – whereas following Brexit, the Pound had crashed to the $1.23/$1.24. That is, JLR was receiving far fewer pounds (20 per cent fewer) per US dollar of sales since it had contracted to sell its US dollars (and buy pounds) at rates around $1.50 per pound.

This is reason behind those large forex losses (estimated at nearly $500 million).

(JLR’s annual report indicates that the company uses both forward contracts and options contracts to hedge currency risk. But the large forex losses indicate that probably the share of options in hedging has to be increased).

What lessons? The JLR and TM experience show (and not for the first time in Indian corporate history) that Indian companies have to look beyond the conventional forward foreign exchange contract to hedge the currency risk in their operations — particularly when currency markets are moving in large ranges and volatility is high.

The forward contract is a simple hedge instrument. It gives price certainty when converting one currency to another. But it is vulnerable to producing large mark-to-market losses or “hedging” losses when market moves are large. It cannot avoid or at least minimise large forex losses when market swings are the norm.

Consider a garment exporter to the UK. If the exports are invoiced in US dollars, the UK buyer bears the currency risk — he may then try to pass on pound sterling weakness by demanding reduction in the US dollar prices of his imports.

The exporter has to be ready to match that demand. He can do that only if he manages the risk inherent in the pound/US dollar exchange rate. That he cannot do with the conventional forward contract, as the TM experience well illustrates.

On the other hand, if the exports are invoiced in the pound, the Indian exporter here bears the currency risk. Then, it is all the more necessary for the exporter to do close management of the pound/ US dollar exchange rate. Again, the forward contract is not suited for this purpose.

Indian companies have to take recourse to simple foreign exchange insurance contracts — termed options contracts to manage risks/losses inherent in large forex moves.

These are contracts like any other insurance contract — say property insurance. The insured has to pay an up-front premium to the insurance seller.

If the insured event — which is the large exchange rate move — happens, the insurance contract pays-off — thereby off-setting the financial loss occasioned by the exchange rate move.

If the event does not happen, fine. The insurance premium paid, of course, is a sunk cost. But, does any insurance buyer regret that the risk has not come to pass?

The writer is a Chennai-based financial consultant

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