How banks can arrest fall of rupee

Dr K Srinivasa Rao

The Indian Rupee's volatility against US dollar has brought to fore the risks of unhedged exposure of Indian entrepreneurs sourcing foreign currency resources either through External Commercial Borrowings (ECBs) or borrowing in foreign currency from Indian banks. Following the globalization and opening up of the Indian economy, Indian entrepreneurs are allowed to borrow foreign currency funds for various permitted purposes. Such borrowings in foreign currency have to have either a natural hedge in the form of exports as a line of their normal business activity or should cover their exchange risks by buying forward cover in forex markets.

Such foreign currency borrowings, when converted into Indian rupee resources, will have dual costs. One, at the time of converting foreign currency into Indian rupees, and the other at the time of reconverting them back into foreign currency to repay the borrowings unless such foreign currency is received in the form of the same foreign currency as export proceeds or a forward cover is taken to hedge the risk.

While every endeavor is made by banks to insist that entrepreneurs hedge the risk despite its costs, many would like to have open position with the expectation that the volatility will be within the manageable range. But that may not happen so in adverse market conditions.

How do the costs or forex risks work in the markets and hit the bottom line of the entrepreneurs unless they follow a prudent policy to hedge their risks? Suppose X borrows US $ 1, 00,000 on April 2 and converts it into IRs @54.30. He gets Rs. 54, 30,000. If he has to repay it on July 5, 2013, @Rs.61.19, the outgo of funds would be Rs.61, 19,000. This puts him at an exchange loss of Rs.6, 89,000. If it is hedged with a 3-month forward cover available @ 107 basis points (one basis point is one hundredth of one per cent) at Rs. 55.37 on April 2, it works out to a premium of Rs.1,07,000.

By incurring the premium costs, exchange risk can be well mitigated. This is just on account of a deal of US $ 1, 00,000. We can well imagine the extent of loss if the deals are in millions of US $ for large borrowers. In a situation when the world is agog with apprehensions of slow recovery of major global markets and instances of venting of opinion of US Federal Reserve or continued nervousness of many of the economies of European Union can send jitters in the market causing depreciation of the currencies of the magnitude that we are experiencing now. In such situations, the Reserve Bank of India (RBI) is right in coming out with draft guidelines suggesting banks to make additional provisions against the unhedged forex exposure of their clients.

The logic is, when the corporate sector gets a hit on account of rupee depreciation against US $, it may default on its commitment and banks may land up with more instances of delinquencies. It then becomes a contributing factor in accentuating the loss. The proposed prudential guidelines of the RBI on dealing with the unhedged forex exposure of bank's clients is based on the premise that around 50 % of their forex exposure at any point of time remains vulnerable to forex market volatility. On an average assumption, such vulnerability may ultimately result in bank's Return on Assets (ROA); the ratio of net profits of banks to total assets of banks is likely to dip by 5 to 6 basis points. We can have a fair idea of the likely impact that the unhedged exposure can make on the profitability of banks.

When the ROA of Public Sector Banks (PSBs) is 0.88 per cent in FY12, a dip of six basis points in it may lead to an erosion of profits of bank to the tune of about 7 per cent. This prudential measure is likely to bring sensitization among the entrepreneurs and banks to keep their position adequately hedged by buying an appropriate hedging product rather than keeping their forex position vulnerable to market gyrations. Indeed a well thought move.

(The writer is General Manager, Strategic planning, Bank of Baroda, at its corporate office, Mumbai. The views are his own)