Sunil Jain: Protective parents, exposed children

PERSPECTIVES

While many believe Indian firms will be badly hit by currency risk if the rupee is allowed to float, a study by Ila Patnaik and Ajay Shah suggests this may not necessarily be true. The two study the rupee's volatility from 1993 till 2006, and correlate this with the unhedged foreign exchange exposure of firms, in this case, of 100 companies whose stocks are the most traded on the exchanges "" these firms have a value addition that adds up to around 10 per cent of the GDP. The two find that during periods when the currency was the least volatile (and that's something you can expect when the central bank defends the currency in a narrow band), companies chose to leave most of their forex exposure unhedged. On the other hand, when the volatility was very high, these companies had a very small unhedged position. The lesson is clear: if the government decides to go in for capital account convertibility, India Inc will adapt to it very quickly and start hedging all forex positions. In other words, an open capital account will not necessarily result in financial fragility of the economy. 
 

Currency exposure versus Exchange risk
Period	Volatility  Level	Currency  Exposure
1. Apr 2, 1993 to Feb 17, 1995	Low	High*
2. Feb 18, 1995 to Aug 21, 1998	High	Low
3. Aug 22, 1998 to Mar 19, 2004	Low	High
4. Mar 20, 2004 to Nov 24, 2006	High	Low
*High exposure implies low proportion of hedging Source: Patnaik and Shah, 2006