A very erudite speech on the topic "Managing currency and interest rate risks" was delivered by Harun R. Khan, Deputy Governor of the Reserve Bank of India, at a seminar in Bombay recently

For banks and their corporate customers, management of currency and interest rate risks has always been a daunting but absolutely vital task. It has become particularly challenging today. The global financial crisis that began in 2007 has vastly exacerbated the market risks. There has been an exponential increase in volatility both in terms of dimension and direction in all classes of financial assets. In the new environment, institutions — both financial and non-financial — have to reckon with movements of currency and interest rates in ranges hitherto not seen and certainly not anticipated. Almost all the conventional and non-conventional methods of containing risks failed, some, as in the case of U.S. housing market, spectacularly and with disastrous consequences for the entire world.

A very erudite speech on the topic “Managing currency and interest rate risks” was delivered by Harun R. Khan, Deputy Governor of the Reserve Bank of India, at a seminar in Bombay recently.

Pointing out how financial market risks affected the real economy, he said that the big increase in volatility had induced uncertainty which, in turn, had a negative impact on the real economy as well. Financial and non-financial companies, unable to anticipate their future, are adopting a more cautious approach to their business planning and employment policies.

Heightened volatility, the new normal?

It is unlikely that volatility will subside anytime soon. In the post-crisis period, the global economy was initially propelled by the big developing economies which more than offset the lacklustre performance of the advanced economies. However, the global slowdown has now caught with India and China, too. The International Monetary Fund (IMF) is just one of the global institutions to lower its forecast for the world economy during the current year.

The slowdown has created uncertainty, which, in turn, had to be countered by some highly unconventional monetary and fiscal policies in the advanced economies. For instance, the extremely loose monetary policy followed by the American Federal Reserve, has the potential to flood the global economy with liquidity. That will have as yet unknown consequences. Global commodity prices could go up, in turn, fuelling imported inflation in countries such as India.

On the other hand, India might be able to tap global capital flows to a larger extent than now. However, given the all-pervasive uncertainty, capital inflows will also be volatile. This is already having repercussions on the exchange and money markets in India.

India’s growing integration with the rest of the world is another factor. It is no longer possible to shield the domestic economy from the vagaries of the global economy. Global risks are now easily transmitted to the Indian economy through a variety of routes — trade, finance, commodity prices and confidence channels. The end result is always heightened volatility.

The government and the RBI have taken a number of steps to help banks and corporates deal with the volatility. Most of these aim to increase the supply of dollars to hopefully iron out fluctuations.

But this might be a case of being extremely short-sighted. For instance, the measures to encourage short-term external debt flows will cause serious funding mismatches if used for long-gestation projects. They might also lead to a ballooning of debt repayments over the near-term. In that event, interest and exchange rate risks will increase."

RBI’s genuine concerns

Measures to augment supply of foreign exchange are one aspect. But the RBI’s current worry is two fold. (1) Many corporates are deliberately or out of ignorance not hedging their foreign currency exposures. According to recent estimates, almost 50 per cent of total outstanding exposures are unhedged. This is an alarming situation. It can not only devastate the concerned company’s balance-sheet but can pose major threats to the macro economy.

(2) Closely related are the second set of worries which arise from the fact that many companies are exploiting the rules to speculate rather than hedge. For some of these companies, foreign exchange risk management becomes a ‘profit centre’, akin to whatever core business they have. In its most basic form, exposures are left unhedged, the objective being to (hopefully) profit from exchange rate movements. Given the current volatility, many of those hopes have come crashing down. Over the past few years, derivative instruments have been used for generating profit rather than to mitigate risks. In nearly all the cases, companies, which gambled on exchange rate, have come to grief.

There is obviously a case for educating customers on the dangers of misusing hedging instruments as well as sterner steps. The RBI has recently suggested that banks should monitor the unhedged positions of their lenders and, if need be, penalise them by charging a higher rate.

In its recent credit policy review, the RBI has pointed out that large unhedged foreign currency exposures have resulted in accounts becoming non-performing assets (NPAs). They are, therefore, a risk to them as well as the financial system. A stringent monitoring of the exposures is, therefore, called for. Among other measures, banks can consider stipulating a limit on unhedged positions of corporates on the basis of policies approved by respective bank boards.