The rupee has given the economy a roller coaster ride for nearly two years now, relegating the stability of 2006 to a distant dream. This is the result of the Indian economy irreversibly integrating with the rest of the world precisely when there has been a manifold rise in global volatility.
The worst of that volatility may be over (commodity prices are coming down) but the global financial crisis has not fully played itself out yet and the spectre of recession still haunts the developed world.
In this scenario, Indian corporates who have to work for stable earnings and incomes for the sake of all their stake holders have their task clearly cut out - be an anchor of stability in a sea of uncertainty.
The corporate sector deserves much of the credit for being the main engine of the historic growth of the last four years (2004-08) but it is yet to establish itself as stable players. With entrepreneurial aggression it has gone out to engage the rest of the world, but the risk taking that inevitably goes with such a phase has found another manifestation. There has been a fair amount of speculation which has resulted in some confusion and unclear policy on dealing with currency risks. This has to end.
A corporate, which is primarily in the business of delivering goods or services, has to clearly and extensively hedge against currency risks. Such a firm's first dharma is to protect the sanctity of its forecasts, explicit or implicit. A currency or commodity trader who puts both his own and borrowed money into play takes a view of the future as part of its business.
But a corporate has no business to do this with the bulk of its income. Only a small portion of past and projected earnings, which have been extensively derisked, can be deployed in an open position. Many Indian corporates, which are substantially promoter-entrepreneur driven, have to make a transition from being essentially risk takers to risk mitigators.
A good part of the present scenario can be explained by inductive logic - trying to find patterns in the past and applying them to the future. But the cardinal truth is, history does and does not repeat itself, especially in the short and medium term.
Despite going up 5 per cent somewhere in the middle, the rupee ended 2006 where it began, thus creating a picture of stability. Then from March 2007 onwards it rose sharply, by as much as 11 per cent, in the next 12 months. Global oil prices were steady through 2006, like the rupee, but then began an inexorable rise that took them over 100 per cent up in the next 12 months.
Through the latter part of 2007, when the sub-prime crisis hit the US and spread its ripples quickly across the developed world, the rupee kept rising undaunted. This was in good part bolstered by the confidence of investors in the India story.
Then the turning point came in January this year when the equity markets peaked. The rupee started falling from its perch but the real tipping point came in March when the US dollar breached the Rs 40 mark. In the last six months, the rupee has lost the 11 per cent that it had gained in the previous 12 months. This is the tumultuous story of the past and explains why firms hedged and didn't hedge, in part or in full.
This story, dramatic in itself, is told in terms of the rupee and the US dollar. But it gets much more complex when the movement of other currencies like the euro, yen and the Swiss franc are bought into the picture.
With this comes in complex hedge instruments whereby a cover is obtained, say, against the dollar via the euro. Hence at a time when the appreciation of the dollar should be greeted with happiness, it is soured by the rupee having gone up against the euro. So the gain from the dollar's appreciation against the rupee turns out to be elusive and underlines the point that complex products have to be first understood and probably should seldom be touched.
Complex as things are, they have been made more so with the start of currency futures trading in India. This is clearly a speculative market. To book a forward cover or an option, a firm needs to have an underlying trade deal. But to operate in the futures market there is no such requirement.
If a firm covers its currency position (receipts from an export deal) in the futures market, it has to still sell the dollars earned to its bank, which charges a commission. So hedging via the futures market can add to costs and make gains in that market partially elusive.
There are few bets today in favour of the bear phase of the rupee being near its end. The easing of commodity prices will ease inflationary pressures but foreign investment flows will not pick up again until liquidity is restored in the global financial system. For its part, the Indian corporate sector's investment plans, which have substantially decelerated will not pick up until demand picks up again.
That will happen only when interest rates go down, which the monetary authorities will not signal until they see inflation firmly under control. This is the received wisdom but guessing the future is hazardous and you can end up looking quite foolish.
Thus there ought to be a strong incentive for firms to crystallise a good part of their future cash flows by hedging through plain vanilla instruments. This is the one indisputable lesson from the tumult of the recent past.
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