Take long-term forward cover on forex exposure: RBI

India Inc must take long-term forward cover to reduce the risks from volatility in foreign exchange rates, is the Reserve Bank of India’s suggestion.

“What this entirely unexceptionable, and highly desirable, strategy does is substitute volatility of the spot exchange rate with that of forward margins at each rollover date. It is empirically and anecdotally established that the volatility of forward margins is far less onerous than that of the spot exchange rate,” said V K Sharma, executive director of RBI, at a function in Bangalore.

Typically, banks offer Indian companies forward cover for short tenures of one month, three months, six months and, at a maximum, one year. Sharma, however, said banks could easily customise a forward cover of five years by choosing a rolling hedging strategy. This would involve simultaneously cancelling and rebooking a short-term forward exchange contract until the desired long-term maturity.

He said such simultaneous cancellation and rebooking of forward contracts for rollover was exempted from the restrictions RBI introduced on December 15 last year to reduce volatility in the foreign exchange market. The central bank had announced guidelines that restricted rebooking of cancelled forward contracts by companies and reduced the net overnight open position limit or trading limits for banks in the forex market.

The rupee depreciated against the dollar by about 18 per cent between August 5 and December 15, 2011, with the volatility almost doubling from five per cent to 12 per cent in this period.

“I would very strongly encourage business and industry to routinely avail of this hedging solution, both to cover the foreign exchange risk of long-term imports and long-term foreign currency borrowings,” Sharma said.

He also advised companies to not be enticed by lower interest rates abroad and suggested they rigorously evaluate foreign currency borrowing options, benchmarking these against comparable rupee borrowing. “Only if business and industry find the long-term foreign currency borrowing costs are lower, on a fully-hedged basis, than the comparable rupee borrowing costs, must they choose such options,” he said.

Sharma said raising equity capital always turned out to be more expensive than debt. Hence, Indian corporate groups should fully provide against the possible liabilities from foreign currency convertible bonds, instead of hoping these instruments would be converted into equity.