The recent sharp fall of the rupee in relation to the dollar must be viewed as yet another manifestation of the extreme volatility that has gripped financial markets, especially foreign exchange markets. Over a two-month period, the rupee has been on a roller coaster ride, gaining nearly 7 per cent in September and losing 4 per cent in October. Although volatility has always been an essential feature of foreign exchange markets, it is only after the onset of the global financial crisis in 2007 that it has increased exponentially. Consequently, banks and corporate entities have to reckon with a far higher degree of exchange risk than ever before. Since there is no way a reduction in volatility can be expected soon, their attention has perforce turned towards strengthening risk management systems to cover exchange rate and interest rate risks that are closely related. Prospects for global growth have diminished sharply as the big developing countries, notably China, India and a few others, who were spearheading the economic recovery, are themselves in the throes of a slowdown. Some unconventional policy measures in the West, such as quantitative easing by the American Federal Reserve to arrest the slowdown, have created uncertainties. These issues are being transferred to India and other developing countries through trade, finance, commodity prices and confidence channels. At the same time, India’s integration with the rest of the world has been growing fast. While this has many positive features, it has made risk management infinitely more complex.
The Reserve Bank of India has been taking steps to minimise volatility. The supply of dollars to the domestic market has been encouraged by relaxing relevant rules on inward remittances. While, as a general strategy that is the right thing to do, some of the specific steps are controversial. The greater leeway given to companies, for instance, to fund their long-gestation projects in India through short-period external commercial borrowings smacks of myopia. It will result in a ballooning of near-term external debt and that will not be good news for the balance of payments. Even more to the point, the RBI has found that many corporates run a serious exchange rate risk by not hedging their foreign exchange positions on the repayment of these loans. The reasons vary from unfamiliarity with hedging techniques — in which case banks need to strengthen their customer education programmes — to a dangerous tendency to speculate on foreign exchange rate movements. The RBI has tried to counter such practices by tightening the rules and directing banks to monitor uncovered foreign exchange exposures more closely.