Private Vice, Public Cost: The Cost of Forex Volatility



Forex Reserves are at a record high, while Hedging levels are at record lows. The good job that Raghuram Rajan has done by managing Re levels, has led to complacency that this will continue. Even as the RBI rues the low hedging levels of nearly 15%, India Inc. switches off the radio and sleeps at the wheel. The result of this indiscipline is that the RBI has to be shoring up the Dollar, and keeping excess Reserves to protect itself against a run on the Re.

Declaimer: This article written was originally in November 2015, and some of the data points may be outdated.

RBI has been putting pressure on the Banks to ensure that Indian corporates are hedged against Re re-depreciation, but these Hedging costs will bring the cost of Fx loans on par with the costs of domestic borrowing. So corporates are tempted to skimp on hedging costs and stay open to the risk of Dollar appreciation, hoping that everything will work out all right. Where have we seen that before?

The understanding of the risk

It’s okay to break your leg, but don’t break your neck. Some risks are acceptable, others are not, our fathers taught us. Then why do we do such things again and again, and why don’t we learn from past mistakes? Our uncovered Fx exposure of $ 70 bn, will force RBI to hold reserves over reasonable needs, thus incurring a cost. The return from US Treasuries is 2.5%, while the Opportunity Cost would be, say, the India GOI Bond rate, 8%. This huge notional loss is being borne by the country to hedge against the private indiscipline of India Inc.

Why doesn’t RBI simply mandate a high Hedge Ratio, thereby creating a steep Forward Curve? And tell corporates to manage their Hedging Costs as best as they can. If people defecate out in the open, their private indiscretion creates a public cost, in the form of higher sanitation costs, public health risks, and the cost of cleaning the city. This comes back to the public in some way, just that the people who defecate don’t pay the full cost.

It is the same with Hedging Costs. India Inc. defecates out in the open, with some sectors more to blame than others. Low-margin traders, like edible oils, tend to build big Fx exposures which come to grief during a ‘flight to safety’.  These are the panicky importers who created the last spike in the Dollar:: Re from 64 to 68, in the Taper Tantrum of mid-2013. The collateral damage on the rest of the economy (and maybe the Congress Party) is well known.

If Hedging of long-term Fx loans were to be made mandatory, the Interest rate arbitrage would disappear, and people would go back to domestic borrowing, creating demand for domestic credit, which has been sluggish. For example, if the edible oil industry was forced to hedge all their imports, this would raise the landed cost of imported oils, making domestic edible oils more competitive, which is not a bad thing. It would correct the mispricing of imports, which is a good thing all around.

And force corporates to manage their cost of Hedging on the domestic Currency exchanges, which would widen and deepen Indian Currency Exchanges, a spinoff benefit. The market-wide impact of introducing this cost would reduce the possibility of a currency crisis, by forcing importers to depend on domestic borrowings. Exporters, on the other hand, would not be affected. At least the spate of corporate bankruptcies that follow each big spike in the Dollar:: Re, would be avoided.

Take the case of the edible oil industry as an example.

Take the case of the edible oil industry as an example. Operating margins are 3%, while hedging costs are ~7%. The industry is fragmented, so if any particular player were to hedge its Fx exposures, it would be driven out of business. So nobody hedges, leaving the entire industry open to ‘Black Swan risk’, i.e. the risk of a sudden spike in the Dollar. The only way to survive in this industry is to look for and be able to have no imports in the pipeline when disaster (i.e. currency crisis) strikes. As one promoter famously told me “I have to choose between dying today, versus dying tomorrow”.

So is it right to say that the entire Bank lending to the Edible Oil sector is dead and that Banks are booking false Interest Income from this sector, to be written off at some future date? If hedging were to be made compulsory, the cost curve of the entire industry would shift upward, and prices would reflect the correct cost (which includes the cost of hedging Fx). That would save everyone, the industry and the Banks that lend to it.

Why are industries that have Domestic Sales in Re, allowed to borrow in Fx at all? Isn’t that a recipe for disaster? Shouldn’t there be a clear directive to Banks that net importers should not be allowed Fx borrowings? If all importers are hedged, there would be no currency crisis, because a lot of import demand would turn to domestic sources, thereby reducing the Current Account Deficit and foreign commercial credit. This would increase domestic corporate credit demand, and give incentives to domestic savers to fund that incremental demand. As a corollary, this would reduce the (RBI) cost of holding excess Fx Reserves.

A culture of Interest Cost Management should be promoted; just the way commodities are being listed to enable producers and consumers to hedge their requirements on the Commodity Exchanges. The simple but dangerous choice, which all lesser human beings are prone to take, is to take on Fx risk to book some (Interest) cost savings. This has always proved counter-productive in the long run, creating vast economic damage to the larger economy.

Can you ban defecation in the open, and put people in jail? I don’t think so, you have to create cleaner options and use education and information to promote good behavior. Just like defecation in the open (and risky sexual behavior) is to be found more among the poor and the ignorant, here too, it is the SMEs and small businesses who are most prone to taking excess Fx risk. To discipline them, you need to mandate to Banks that foreign borrowings are restricted to those who show demonstrated ability to manage Fx Risk.

Explain the  Credit Risk

This brings us to the Banking system that is to monitor all this. I find that frontline PSU  Bank officers know less about Fx than they know about Banking, so these assessments should be centralized with the Credit Risk cells at the Central Office. And no Fx loans (PCFC or ECB) should be disbursed until there is a clear certificate from the Credit Risk Deptt that the borrower is capable of looking after himself.

For those who remember, the Structured Derivatives Scam (of circa 2008) was about private Banks loading invisible Fx Risk onto corporate Balance Sheets, to book huge Treasury profits on their books. The policeman turned rapist, and some Banks got a huge rap on their knuckles for this. If instead, these same Banks were to be given the mandate to sell Interest Cost Reduction structures for domestic borrowers, they would end up taking on the Fx risk on themselves. As domestic companies reduce Risk, some Banks might find it profitable to take Fx Risk onto themselves, creating quite a profitable niche for their bottom lines.

However, the socialization of the costs of private vice should be managed. This happens in many places, Greece being a good example, but when it affects a country’s macro-stability and the relative wealth of its population, it is a very big hidden cost that must be brought to the forefront of public consciousness. The higher Risk Premia attached to higher volatility holds back foreign equity investment, leads to higher borrowing costs in the international market, and reduces the stature of the currency and country in the eyes of international investors.

One look at Switzerland and you can see how a currency can build a country. Whether it is a haven, or a city Financial Centre (Singapore or Hong Kong), you will find that these countries reap huge benefits by installing the rules of good behavior in their country’s social fabric. Without aspiring to a similar status, a large country like India can hardly afford to allow such risky behavior. At the other extreme, Russia has shown that even a large country can be brought down to its knees by promoting cronyism, another pattern of bad behavior where private vice has caused public disaster.



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