Forex reserves are at a record high, while hedging levels are at a
record low. The good job that Raghuram Rajan has done by managing rupee
levels has led to complacence that this will continue. Even as the RBI
rues the low hedging levels of nearly 15 per cent, 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 rupee.
The RBI has been putting pressure on banks
to ensure that Indian corporates are hedged against rupee depreciation,
but these hedging costs will bring the cost of forex loans at par with
the cost 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?
It's
OK to break your leg, but don't break your neck. Some risks are
acceptable, but others are not, as our fathers told us. Then why do we
do such risky things again and again, and why don't we learn from past
mistakes? Our uncovered forex exposure of $70 billion will force the RBI
to hold reserves in excess of reasonable needs, thus incurring a cost.
The return from US Treasuries is 2.5 per cent, while the opportunity
cost would be, say, the India GOI bond rate of 8 per cent. This huge
notional loss is being borne by the country to hedge against the private
indiscipline of India Inc.
Why doesn't the 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 cost, public-health risk and the
cost of cleaning the city. This comes back to the public in some way,
just that the people who defecate don't really 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 forex exposures, which come to grief
during a 'flight to safety'. These are the panicky importers who created
the last spike in the dollar-rupee exchange rate from 64 to 68 rupees
to a dollar 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 forex loans were 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 were forced to hedge all its
imports, this would raise the landed cost of imported oils, making
domestic edible oils more competitive. This would correct the mispricing
of imports, which is a good thing all round.
Corporates should
be forced to manage their cost of hedging on domestic currency
exchanges, which would widen and deepen Indian currency exchanges, a
spin-off 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 follows
each big spike in the dollar-rupee exchange rate would be avoided.
Take
the case of the edible-oil industry. Operating margins are 3 per cent,
while hedging costs are around 7 per cent. The industry is fragmented,
so if any particular player were to hedge its forex exposures, it would
be driven out of business. So nobody hedges, leaving the entire industry
open to 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 the disaster (i.e., currency crisis) strikes. As
one promoter famously told , '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 actually dead, and that banks
are booking false interest income from this sector to be written off at
some future date? If hedging were 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 forex). That would save
everyone, including the industry and the banks that lend to it.
Why
are industries that have domestic sales in rupee allowed to borrow in
forex 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 forex
borrowings? If all importers are hedged, there will 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 the domestic corporate credit demand and
give incentives to domestic savers to fund that incremental demand. As a
corollary, this would reduce the RBI's cost of holding excess forex
reserves.
A culture of interest-cost management should be
promoted just the way commodities are listed to enable producers and
consumers to hedge their requirements. The simple but dangerous choice,
which all lesser human beings are prone to taking, is to take on forex
risk to book some (interest) cost savings. This has always proved
counterproductive 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 behaviour. Just like
defecation in the open (and risky sexual behaviour) is to be found more
among the poor and the ignorant, here too it is SMEs and small
businesses which are most prone to taking excess forex risk. To
discipline them, you need to tell banks that foreign borrowings are
restricted to those who show demonstrated ability to manage forex risk.
This
brings us to the banking system to monitor all this. I find that
frontline PSU bank officers know less about forex than they know about
banking, so these assessments should be centralised with the credit-risk
cells at the central office. And no forex loans (PCFC or ECB) should be
disbursed until there is a clear certificate from the credit-risk
department 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 forex risk onto corporate balance
sheets to book huge Treasury profits on their own books. The policeman
turned rapist, and some banks got a huge rap on their knuckles for this.
If instead, these same banks were given the mandate to sell
interest-cost reduction structures for domestic borrowers, they would
end up taking on the forex risk on themselves. As domestic companies
reduce risk, some banks might find it profitable to take forex risk onto
themselves, creating quite a profitable niche for their bottom lines.
But
socialisation 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 public
consciousness. The higher risk premium attached to higher volatility
holds back foreign equity investment, leads to higher borrowing cost in
the international market and reduces the stature of the currency and
country.
One look at Switzerland and you can see how a currency
can build a country. Whether it is a safe 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 behaviour in their
country's social fabric. Without aspiring to similar status, a large
country like India can hardly afford to allow such risky behaviour. 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
behaviour where private vice has caused public disaster.
