## Monday, January 20, 2014

### The problem of unhedged currency risk of corporate India: Comments on the recent RBI regulation' on the unhedged currency exposure of the customers of banks

#### How do firms get exposed to currency risk?

Many people think that a firm gets exposed to currency risk owing to imports, exports and foreign borrowing. This is an incomplete picture.

Suppose a firm switches from importing steel to buying imported steel from a domestic dealer. Does this change anything about its exposure to the world price of steel, expressed in rupees? The key insight is that things that can be traded across the border easily have import parity pricing': the Indian price is just the world price multiplied by the exchange rate. There is no Indian price of steel. There is only the London Metals Exchange (LME) price of steel, multiplied by the exchange rate. An Indian firm may buy or sell steel against a domestic counterparty, but it experiences currency exposure exactly as if it were importing or exporting steel.

For all products where cross-border goods arbitrage works well, i.e. for all tradeables', the Indian domestic price is close to the world price expressed in rupees. These product prices fluctuate with the exchange rate. These transactions are influenced by the exchange rate -- even if the buyer and seller are both domestic firms.

What is the currency exposure of the representative firm that processes tradeables? We can obtain intuition through a simplified calculation. Let's assume a firm consumes tradeable raw materials and makes a tradeable output. The typical values for an Indian non-financial firm in 2011-12 were:

 Total income 100 Raw materials purchased 58.45 Other operating expenses 27.66 Operating profit 13.88

I'm making the simplifying assumption that this is a firm like an engineering firm, which consumes tradeable raw materials and sells a tradeable like a ball bearing. Simplifying assumptions have been used above, such as merging the purchase of finished goods into the raw materials purchased', and treating all energy expenses as other operating expenses' even though some of this is tradeable.

By the logic of import parity pricing, for all practical purposes, this firm imports Rs.58.45 and exports 100. This is because there is no difference between selling Rs.100 of ball bearings on the domestic market vs. exporting ball bearings as the Indian price of ball bearings is the same as the world price of ball bearings (as ball bearings are tradeable and goods arbitrage is feasible). Similarly, for all practical purposes, this firm is an importer of Rs.58.45 of imported raw materials. That is, it's in the tradeables processing business; what it does is tantamount to importing raw materials, adding value, and re-exporting the output.

For all practical purposes, this firm has the currency exposure owing to its net exports, i.e. the exposure of someone who exports Rs.41.55. Suppose the INR/USD depreciated by 10%. The total income of the firm would go up to 110 and the raw materials purchased would go up to Rs.64.295. Other operating expenses are non-tradeable and would not budge, in partial equilibrium. Hence, the operating profit would become 110-64.295-27.66 or 18.045. This is an increase of Rs.4.16 which is the same as 10% of the net exposure of Rs.41.55. For all practical purposes, the firm is a plain and simple exporter with exports of Rs.41.55.

This gives us one useful insight: If all raw materials are tradeable and if all finished goods are tradeable, on average, the non-financial firms of India have the currency exposure of an exporter, and stand to gain from depreciation.

This analysis helps us think about measurement of currency exposure. To understand the currency exposure of a firm, you have to:

• Classify all outputs as tradeable vs. non-tradeable (this has nothing to do with their being exported by the firm or not).
• Classify all raw materials as tradeable vs. non-tradeable (this has nothing to do with their being imported by the firm or not).
• Work out projections for these.
• This gives the net unhedged exposure owing to the natural business of the firm.
• Layer on top of this the cashflows emanating from foreign currency denominated borrowing.
• This gives the overall picture for the exchange rate exposure of the firm.

#### Analysing what RBI said on 15 January

On 15 January, RBI put out a "regulation' titled Capital and provisioning requirements for exposures to entities with unhedged foreign currency exposure. In this, they ask banks to do greater provisioning and hold more capital when faced with a borrower who has unhedged currency exposure.

I have a few concerns with what has been done here.

1. This is unsound micro-prudential regulation. The risk faced by a lender is about only two numbers: Pr(default) and loss given default. That's it. Everything else is an input that goes into making these two numbers. If unhedged foreign currency exposure impacts upon the failure probability or upon the LGD, then it's correct to use it in internal models that generate a failure probability or the LGD. It is wrong to think of an additional layer of prudential regulation to address unhedged foreign currency exposure. For an analogy, greater leverage means that Pr(default) goes up. Does this mean that banks will now have enhanced provisioning or increased capital required to cope with the increased leverage? For another example, the volatility of cashflow impacts upon Pr(default). Does this mean that banks will now have enhanced provisioning or increased capital required to cope with firms that have more volatile cashflows? I could go on and on.
2. This is unsound measurement of unhedged currency exposure. The words import parity pricing' do not occur in the RBI document. They think in terms of direct exports and imports. Further, they say "export revenues (booked as receivable) may offset the exchange risk". For a firm like Infosys, it's perfectly safe to borrow in dollars for a 10 year horizon, knowing that for the next 10 years, export revenues are going to come along, even if this is from clients who are not known today.
3. This is unsound regulation-making process. If the due process in the Handbook had been followed, the quality of regulations would go up. In part, this is about the basic hygiene of the rule of law. As an example, under the Handbook, a regulation would not be a letter. In addition, the formal process of identifying the market failure, stating a clear objective, doing the cost benefit analysis and consultation would have caught the mistakes. The formal regulation-making process from the draft Indian Financial Code, and the Handbook, is the process design for a superior financial agency.

Suppose we believe that unhedged currency exposure is a problem for India, and not for banks, and that we're merely using the regulation of banks as a mechanism to attack that problem. This would stave off the first problem (`this is unsound micro-prudential regulation of banks'): RBI could respond saying "we know this is unsound micro-prudential regulation, but this isn't micro-prudential regulation". But it would not solve the other two problems, and it raises two fresh concerns.

First, if there is a concern on the scale of India, and an intervention is undertaken in one part of the financial system (Banking), it will have little impact on the economy as a whole -- all that will happen is that the market share of banks in the credit market will go down. This shift in market share will be a distortion as it will constitute industrial policy in the form of RBI favouring one technology (non-bank lending) over another (bank lending).

Second, this raises concerns about accountability. The powers obtained by a financial agency for a specific purpose should not be misappropriated for other purposes. Once we start going down this slippery slope, we will get powers of micro-prudential regulation getting used to foster GDP growth in Himachal Pradesh. A few paragraphs down, I argue that the problem of unhedged currency exposure is rooted in inappropriate monetary policy (i.e. exchange rate management) and inappropriate regulation of organised financial trading. The problem of unhedged currency exposure was not born in mistakes of banking regulation and should not be addressed by modifying banking regulation.

#### How to combat unhedged currency exposure

I have been closely associated with enterprise hedging of certain firms and even to the management of the firm, it is not easy to precisely understand currency risk and hedge it. The true extent of exchange rate exposure for a non-financial firm is very hard to observe for an external observer such as a bank.

Unhedged currency exposure of firms is a real problem. Many countries have experienced serious problems with non-financial firms that got damaged as they had borrowed in foreign currency and hoped that the government would prevent depreciation. We should not ignore it. There are two channels to fighting this:

1. The problem of moral hazard. Firms will be careful about unhedged currency exposure when they know that the government will not manage it for them. As long as a government promises that extreme volatility of the INR will be prevented, it is advantageous for firms to leave tail risk unhedged. By doing this, the firm that has unhedged foreign exchange exposure free rides on RBI; its private gains from not doing risk management are offset against the costs to society of RBI having an exchange rate policy. The paper Does the currency regime shape unhedged currency exposure? by Ila Patnaik and Ajay Shah, Journal of International Money and Finance, 2010, finds there is this kind of moral hazard in India. To solve the problem of moral hazard, RBI should stop having a currency policy and should clearly say so in order to ensure that the firms of India know they are on their own, and have to do their own currency risk management.
2. The problem of incomplete markets and barriers to hedging. Even if a firm was sensible and wanted to hedge, RBI is working hard to prevent the firm from hedging. The rules about the use of the OTC market prevent correct measurement of enterprise-risk based on import parity pricing. The onshore market is illiquid, but Indian firms are prevented from getting their hedging work done on the superior NDF market. The exchange-traded currency futures market has been damaged by RBI, to make sure that it is not a viable venue for currency hedging. If Infosys tried to obtain a 3-year hedge from the private market, the prices are quite adverse.

This is a good example of the problems that come from mixing up multiple functions inside one agency. A financial agency which did micro-prudential regulation for banking would be technically sound and not make the mistakes identified above on provisioning and capital. A financial agency which dealt with organised financial trading would deliver a sound Bond-Currency-Derivatives Nexus without conflicts of interest, and the problem of incomplete markets and barriers to hedging would go away. If RBI had no role in banking regulation and no role in organised financial trading, the quality of monetary policy would go up. When each agency has clear objectives, each one will be accountable and more likely to deliver results without conflicts of interest.

#### Conclusion

The unhedged currency exposure of Indian firms is a big problem. It is an important concern for policy makers. But it makes no sense to go after it by asking banks to hold greater capital when lending to firms that are considered unhedged, based on an incorrect framework for thinking about the currency risk of firms.

We must address the root cause. If RBI had no currency policy -- and clearly said so -- the moral hazard would be removed. If RBI got out of the way, then the Bond-Currency-Derivatives Nexus would find its feet and firms would be able to hedge. The problem of unhedged currency exposure of firms is caused by inappropriate macro/finance policy at RBI, and the solutions lie there.

Please note: LaTeX mathematics works. This means that if you want to say $10 you have to say \$10.