Depreciating rupee: Managing currency risk
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Depreciating rupee: Managing currency risk
Indian rupee in 2013 so far…
After remaining within the range of 50−55 during most of 2012, the Indian rupee continued to trade in the
same range until May 2013. One of the first major events that took place during that period was gold prices
crashing globally to close to 15% within a span of two trading sessions in April 2013. This sudden crash
triggered a surge in import of gold by India on account of the huge domestic demand. Data announced on May
13 indicated that the deficit witnessed on 13 April had increased by 72% over that announced on 13 March, on
cheap gold imports surge. Silver and gold imports were up by 138% to US$7.5 billion, as compared to last year,
and this continued to put pressure on the current account deficit. To add to the worry, S&P confirmed India’s
rating at BBB, with the negative outlook highlighting the uncertainty of the Government’s ability to support
investment growth. May 2013 saw the rupee losing over 5% against the US$ and crossing the INR56/US$ mark
after a year.
In mid June 2013, the US Federal Reserve’s Federal Open Market Committee (FOMC) hinted that it is likely to
begin tapering the country’s quantitative easing program in 2013 and wind it up altogether by mid 2014 if the
US economy witnesses the economic recovery expected. This was enough reason for global investors to pull out
money from most emerging markets and FII sold over US$6 billion in Indian debts and equities, putting further
pressure on Current Account Deficit (CAD) financing. Despite the Government’s measures to curb gold imports,
CAD hit a record high of US$87.7 billion (or 4.8% of India’s GDP) in fiscal year 2012/2013 (from US$78.2 billion
a year earlier) on increasing imports of oil and gold. For the second consecutive month, the rupee lost by more
than 5% in June 2013 and touched a psychological barrier of INR60/US$ for the first time, even after the RBI’s
intervention.
With currency market becoming extremely volatile, July 2013 can be considered the “RBI intervention month”
due to the RBI shifting its entire focus on managing the volatility in the country’s currency market. The market
continues to debate whether this was the right move. The RBI began squeezing short-term INR liquidity in the
market to curb speculative trading in the currency market and raised the Marginal Standing Facility and Bank
Rates by 200 bps to 10.25%. It also put a market-wide cap of INR75000 crores that banks can borrow daily
from it. A week after that, the RBI further tightened the liquidity of the rupee by reducing the overall limit for
borrowing from it to 0.5% of individual bank deposits. The RBI also made mandatory for banks to maintain 99%
(against 70%) of their daily cash reserve ratio (CRR) requirements with it. As a result of these measures, short-
term rupee interest rates shot up to over 200 bps and 10Y benchmark bonds yields up to 90 bps. However, this
had limited results with the rupee moderately appreciating from INR60/US$ to INR59/US$. In its widely
anticipated monetary policy initiated on 13 July, the RBI maintained all its policy rates unchanged. However,
with no further measures being taken by it and the continued pressure on CAD saw the rupee losing yet again,
although moderately. (All these measures helped the rupee lose only 1.73% on 13 July.)
The first few trading sessions on 13 August saw the rupee losing further ground, breaking a new psychological
barrier — INR61/US$ — and making it the worst performing Asian currency against the US$ at a loss of 13% in
2013.
Depreciating rupee: Managing currency risk 2What’s next for the Indian rupee…
It seems definite that the rupee will continue to be under pressure in the short term due to the volatility of the
currency market.
As of 2 August 2013, India’s forex reserves stood at US$280 billion — a three-year low after depletion of more
than US$16 billion since 13 May due to the RBI’s intervention at various levels to support the rupee. India’s
short-term debt, which will mature in March 2014, amounts to US$172 billion. The current account deficit
amounts to nearly 5% of the country’s GDP and much of its increased CAD has been funded by debt flows. It is
important to note that India’s short-term debt, which will mature in March 2014, constitutes nearly 60% of its
forex reserves. Theoretically this means that if India’s capital flows were to dry up due to some unforeseen
events and NRIs stopped renewing their deposits in the country, 60% of its forex reserves might need to be
deployed to pay back foreign borrowings due within a year. This will definitely restrict the RBI’s ability to
intervene in the forex market to prevent the rupee from depreciating further and put additional pressure on the
currency market.
Apart from meeting its debt-repayment obligation of US$172 billion by 31 March 2014, India needs another
US$90 billion of net capital flows to meet its current account deficit, which has been projected at 4.7 % of its
GDP by the Prime Minister’s Economic Advisory Council (PMEAC) for the 2013−14 fiscal.
As can be seen from the markets (as on 6 August 2013), the 1M US$/INR Fx Forward is trading at 62.23 (at an
all-time high premium of 52 paise) and the 1Y US$/INR Fx Forward is trading at 66.61 (at an all-time high
premium of 490 paise) over an all-time high spot of 61.70. This is a clear indication of the pressure building on
further weakening of the rupee.
Events to watch out for…
India clearly needs to attract more capital inflows to widen its CAD. The Government has already issued various
directives to curb import of gold. It has taken decisions on easing its FDI policy, issuing NRI bonds, global
events, e.g., the final print on “QE tapering.” In addition to this, every macro-economic data announcement
includes GDP-related data, CAD/trade deficit numbers and industrial output, Inflation has the potential to
adversely affect the performance of India’s equity market. Any data that is below expectations can trigger
losses in the equity market and put the rupee under further pressure.
Depreciating rupee: Managing currency risk 3Risk management
Risk management includes identification, assessment and prioritization of risks, followed by coordinated and
economical application of resources to minimize, monitor and control the probability and/or impact of
unfortunate events or maximize realization of opportunities. The following details the various stages involved:
Identification of risk
Financial markets are dynamic and efficient but unpredictable. It is extremely difficult to predict them, which
can result in risk for an organization. Considering the volatility witnessed in today’s currency market, it is
critical for management to first identify the risks faced by their organizations. Management of currency risk
must start with identification of economic exposure each company faces in its business.
For instance, an IT company, which is a natural IT exporter to US and European clients, will have a natural
exchange rate risk on US$ and €/£ vis-à-vis the rupee, since finally, what matters is its INR balance sheet.
Similarly an oil importer, whose typically billings are conducted in US$, will have exposure to the US$ against its
INR books in India. This looks fairly academic on paper, but it is extremely critical for management to
understand its organization’s business profiling, chain of operations and supply dependencies, and accordingly
identify its economic exposure to currency risk. It is pertinent to understand the nature of transactions
conducted by organisations, which lead to currency risk. To elaborate, in the case of foreign currency
borrowings/ECB, most companies look only at their exchange rate risk, but given that servicing of such loans is
dependent on interest rates, they should also focus on their interest-rate and currency risks.
Interest rate and currency risks, which are interlinked mathematically, are dependent on various factors.
Announcement of key macro-economic data in different currencies can adversely affect organizations’ interest
exchange rates. Some key data figures that typically affect interest and exchange rates include GDP-related and
inflation data, factory and industrial output, unemployment-related data and monetary policy announcements.
All such events need to be closely followed by management, since these can be a source of risk.
Depreciating rupee: Managing currency risk 4Measurement and control of risk
Having identified the risks, it is equally critical to measure them correctly. The simplest measure includes
quantifying the Net Open Position in different currencies. Most organizations are unable to exhaustively
quantify their exposure across various currencies. This requires a detailed understanding of a business, areas of
operations and how accounting of all transactions is executed. The CFO of an organisation should ensure that all
exposures are specifically accounted for and well represented in its treasury and integrated systems. Unless an
organization measures its currency positions correctly, it is impossible for further action to be taken by it. What
is of paramount importance in this procedure is the speed and transparency of information flow between the
organization’s finance, business and treasury functions.
Once risks are correctly measured, the next step is to determine how they should be manages. In common
parlance, the tool to manage risk is called “hedging.” Which instruments/products should be used for hedging
risks? It is extremely important to understand underlying risks that every derivative product carries. Just as
there are no free lunches, there are no “high rewards with low risks.” There are various derivative products
available for hedging currency risks, right from the simplest “Fx Spot/Forward to Fx Options” to complex
structured products. Every product has its own leveraging effect and costs associated with it. It is up to
management to understand, define its priorities, i.e., whether the ultimate objective is making P/L out of
currency fluctuations or real hedging and mitigate the risk of losing money. Markets work on “greed” and “fear”
and it is extremely important to find the right path through this without losing one’s focus on one’s real
objectives. The suitability and appropriateness of every product needs to be studied in light of organizational
goals before entering “new” business.
Control of risk, in a nutshell, refers to defining the risk appetite of an organization. At how much is an
organization willing to set its loss limit? Different levels of risks limits can be structured to ensure that no
individual can exceed its authority. Value at Risk Rigorous VaR & Stop Loss limits need to set and more
importantly, tracked and adhered to, regularly. Limits must be set on an organization’s exposure to different
currencies to restrict its operations to selected countries. CFOs should ensure a clear distinction between an
organization’s trading and hedging position, and ensure that while hedging trades, all supporting
documentation is in place to prove the hedge effectiveness of their organizations. It needs to be ensured that
the positions of all derivatives are mark-to-marketed (MTM) on a regular basis to obtain a fair/market value of
financial instruments. This can help management take an informed decision on what is the impact of derivative
trades on an organization’s bottom line. The RBI has already issued detailed guidelines for dealing in the foreign
exchange market, which should be complied with.
Broad risk categories and common tools
It is important to understand three broad categories of risk:
Credit risk: Credit risk relates to loss due to a debtor's non-payment of a loan or other line of credit —
either the principal or interest (coupon) or both.
Market and liquidity risk: Market risk is defined as risk of losses on on-balance sheet and off-balance sheet
positions arising from movements in market prices. Liquidity risk is the risk an organization faces when it
cannot meet its payment obligations as and when they fall due. The broad categories of such risk include
interest rate risk, currency risk, commodity risk and equity risk.
Operational risk: Operational risk is the risk of incurring an economic loss due to inadequate or failed
internal processes or external events, whether such events are deliberate, accidental or natural
occurrences. Management of operational risk is underpinned by an analysis of the cause-event-effect
chain.
Depreciating rupee: Managing currency risk 5Some important and widely used risk management tools:
Value at Risk (VaR): VaR measures the maximum loss that an organization can suffer at a particular level
of confidence for a specific holding period. This tool provides a broad idea to its management on the risks
that the organization is running in its books. This is a common market risk tool.
Potential Future Exposure (PFE): Potential Future Exposure (PFE) is defined as the maximum expected
credit exposure over a specified period of time, calculated at a level of confidence. This is also a common
credit risk tool.
This is a multi-layered limit structure on respective currencies, interest rates, stop loss limits, etc.
Asset and liability gapping: Limits are set on gapping for management of ALM/liquidity mismatches.
Closing remarks…
The global crisis during 2008 has taught us that there is a likely convergence between the sub-categories of
risks mentioned earlier, especially credit and market/liquidity risk. Globalization of Indian markets has made
them vulnerable to any global event. Markets are volatile, will continue to be unpredictable and surprise us with
un-anticipated events. These dynamics call for sophisticated risk management frameworks, solutions and
processes to manage risks with an enterprise-wide view rather than in the traditional way of managing risks in
silo. In this volatile scenario, organizations should not only be reactive but need to be proactive as well. They
should have the best risk-management practices in place to stay ahead of the market. A strong risk-
management framework in an organization is a role model for regulators, customers, and most importantly,
shareholders, reassures them that it is resilient to future shocks and is making a whole-hearted effort to ensure
that its bottom line is predictable within an acceptable range. This also contributes to the organization’s
competitiveness by enabling enhanced management insight in the business, allowing it to take advantage of
future opportunities when others will keep playing the “catching game.”
One earlier said, “No risks – no reward,” but now it is time to say, “Better managed risks – better rewards.”
This article is produced by Financial Services Risk Management Team of EY
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