Is The Cart Before The Horse ?
Forward cover is one of the methods export / import intensive companies use to protect (hedge) themselves against exchange rate fluctuations. Recognising the need to make available better hedging facilities to the corporate sector, the Reserve Bank of India (RBI) announced certain modifications to the rules in this years credit policy.
It has allowed authorised dealers (designated banks) to run a swap book within their open positions (currency exposures that have not been hedged) upto certain limits without the RBIs prior approval. Earlier Indian companies were allowed to take a forward cover (or enter into currency swaps ) only for a period of up to six months to a year, with longer tenures requiring explicit RBI approval (see box: Forward booking freedom).
Armed with this facility, corporates requiring forward cover can now hedge themselves for a longer period, which gives them the opportunity to take advantage of exchange rate fluctuations.
Indian corporates today are unable to hedge their external commercial borrowing inflows which currently get converted to rupees at the spot rate when they are received. On the other hand, there are foreign institutional investors (FIIs) in the country who cannot use the forward market to hedge their rupee incomes (to be converted to dollars) and their dollar inflows. The need of the hour is to try and match their requirements, says V. Ravi Kumar, chief dealer, ABN AMRO Bank. Currently, companies
opt for a six month roll-over forward cover to hedge their trade and finance related currency exposures for periods beyond six months.
How will the new system help? Consider this example. A company has an overseas borrowing of $ 1 million at a fixed rate of LIBOR plus 50 basis points (5.5 +0.5 i.e. effectively a rate of 6%) in the ECB market for a period of five years. Also let us assume that it has to repay the loan in ten instalments.
The company can hedge this risk through with a series of forward purchases 11 in this case; buying one contract of rupees against dollars at a certain exchange rate for the period when it supposed to receive the loan amount; again buying 10 contracts, matching the number of instalments, of dollars against rupees in order to repay. The crucial point is that the conversion is pre-determined.
Another precondition for forward currency swaps is that the counterparties (i.e. the two parties who enter into a transaction to exchange the dollar inflows of one with the rupee outflows of the other) should have differing but mutually complementary needs for identical amounts and maturities. Let us take the previous example: repayment schedules are on reducing balance method where the principal amount goes on reducing proportionately every year and the interest is charged on the principal outstanding making the initial installment of $ 1,60,000 for the first year and ending with an installment of $ 1,06,000 for the fifth year.
Now considering that the company would like to hedge it there must be a corporate which has similar dollar outflows during the same period of five years. But if this condition is not fulfilled, the RBI has permitted an intermediary who normally is an authorised dealer to step in and take the residual position (which is the gap between the actual and the required amount) on his books. Yet most authorised dealers avoid this kind of commitment. They go in for matching the inflows of one their clients with the outflows of another
without taking any position on their books.
An immediate concern here is the lack of market makers in this area. Market sources feel that large banks alone can undertake this role. With their huge FCNR deposits, banks like the SBI would need to hedge the dollar inflows as well as outflows. They are also capable of maintaining large open positions because of their gap limits (see box : Aggregate gap limits). Yet, few banks seem to be active here.
The problem, according to market sources, is that their FCNR deposits are typically of one year tenure. Hence, they find it difficult to swap rupees against the dollar and vice versa for a longer term. This may be a temporary problem till the rupee becomes fully convertible, when assets and currencies can be sourced world-wide in which case the swap transactions will be easier to perform.
The other kind of swap that is possible is an interest rate swap. Here, a company borrowing money in the overseas market on a floating interest rate swaps it for a loan in the home currency for a fixed rate (which is normally lower than what it would normally have to pay in the domestic markets). This primarily arises because of different borrower perceptions by different markets. For example even if a AAA corporate approached the
Indian markets the lowest rate at which it could get a loan is the PLR which is around 14 per cent today.
Yet in the international markets two AAA corporates like say Reliance and an Essar may be perceived differently. Hence while Reliance may get a fine rate in the international markets Essar may not. Corporates would be willing to swap their rupee liabilities for dollar liabilities and take advantage of the lower cost loans overseas along with the exchange risk.
At the same time the corporate who secures the foreign loan at say LIBOR plus 50 - 100 basis points (or even less) could swap it for a rupee loan at say 10 per cent (which is much below PLR) to get out of the exchange risk. There have been sporadic deals reported in the past such as the ICICI - Indian Petro Chemicals deal as also the ICICI - Ahemdabad Electric Company deal but primarily with the RBI permission. In each of these cases, ICICI took on the rupee liability and passed on the dollar liability to the corporates. Now with the swaps being allowed there has been renewed interest and ICICI is negotiating with a lot of corporates for such deals.
The issue of pricing
Moreover, the viability of a swap transaction hinges on its pricing. Pricing of currency swaps is based on expectations of the movement of interest and currency rates. In India today there does not exist any benchmark reference interest rate due to the lack of a term money market, point out market sources. The erratic behaviour of call rates, the only reference rate so far, in India makes these calculations difficult and unreliable.
World-wide, the call market is a residual market which is used to meet temporary imbalances whereas the term market is the primary market from where the banks borrow. But in India it is exactly reverse with the call being the primary and for all practical purposes the only market, says Kiran Umrootkar, senior vice president - treasury, Tata Finance.
The determination of the future price of the currency is also extremely difficult as of now because of the uncertain nature of the RBI intervention in the forex market. With a steady spurt in dollar inflows since 1994 - 95, the RBI has been forced to purchase dollars to stop the rupee from appreciating. And to nullify the inflationary effect of increased money supply, it has been forced to suck out excess rupee from the system. These open market operations of the central bank have a strong influence on the interest and the exchange rates prevailing in the market.
The market is therefore confused about the future movement of exchange rate and the interest rates. With the CAC committee recommending the use of Real Effective Exchange Rate (REER) (see box: REER - the solution) as a basis for the intervention the degree of uncertainty will gradually vanish.
Till such time that the term market develops the method of pricing long term swaps will always be ambiguous.