At a time when the domestic currency is weakening, it may be good for the exporters of domestic commodities, but it may be pretty risky for the exporters dependent on imported goods. And the volatility that has of late insidiously crept into the currency movement leaves their prospects even more clouded. In India, one such industry is gems and jewellery (G&J), which contributed about 13% to the country?s estimated export earnings for the first quarter of FY 2007-08. With the estimated trade deficit accounting for about 8% of the GDP during FY 2007-08 and the sector providing employment to about two million people (as per GJEPC), there is no doubt that continued volatility in prices coupled with the current meltdown would give the country?s economic managers more sleepless nights in preventing further erosion in the economy and external trade.
A quick look at the volatility that recently existed in the RBI notified USD/INR daily rates and the unit value realisation by the exporters revealed the kind of nightmare the gems and jewellery industry would be experiencing under these conditions. Till the year 2006-07, when the annualised volatility in USD/INR rate was about 5% or below, the value realised on re-exports of polished gems had been on an upward curve aided by the booming markets. However, during April-September 2007, when the forex (USD/INR) annualised volatility increased to 6.78%, the value realised by the exporters, particularly the re-exporters of polished gems, declined abruptly. Further, as gold is heavily imported for domestic consumption, the gold jewellery industry is exposed to annual forex risk of about Rs 7,000 crore, based on the volatility in the RBI reference rate for 2008 (till October 31) and price risk of above Rs 20,000 crore based on volatility in MCX gold spot prices. If not appropriately protected, the high volatility that now exists in the currency markets can simply leave the balance sheets of domestic gems and jewellery firms in the red. And if this happens, it would have a cascading effect on the country?s external trade balance, economic growth, employment, and so on. To tide over the crisis, companies in the Indian G&J sector would need efficient stock management, production decision, and competitive pricing. And they can achieve all this by participating in the markets that provide them with a transparency platform to lock in their margins.
Futures and options are not alien to the G&J industry in India as the sector has remained a major driver of growth for the domestic OTC forward markets with a mutually beneficial existence. Needless to say, the jewellery sector remains one of the major players in the growth of gold futures trading in India, making the country the world?s third largest market. In fact, trading in gold derivatives in India has come of age and has helped the industry in a big way to cope with the current high volatility in gold prices by sharing the risk with other participants in the market rather than doing the same in traditional ways of passing the risk onto the raw material supplier or the end-product consumer. In addition, the fact that gold derivative contracts traded on Indian exchanges are settled in the Indian currency helps domestic traders in the gems and jewellery industry take care of both the international gold prices and USD/INR rate as both the sets of markets are captured through a single derivative instrument. An analysis of the international and Indian prices of the yellow metal, and currency rates shows that a part of the risk, though small, is still left uncovered by these derivative contracts. And this could be covered if there are transparent futures price signals from currency derivatives and risks are arbitraged between the commodity and currency markets.
The G&J industry, which initially belonged to a class of skilled people, started taking a corporate shape in tandem with the socio-economic changes in India. This transformation increased the risks for the industry multifold, besides the challenge of meeting the growing consumer demand in terms of price, design, and availability. Pitted against intense competition, jewellery firms started resorting to various pricing options including mark to market, mutually agreed/polled daily selling price for the market, etc., leaving behind the traditional method of marking it to the cost (risk free). While the latter models in themselves indicate higher risk for jewelers in terms of input costs and output prices leading to their fluctuating fortunes, gold futures arrived on the scene as a saviour by providing them with an avenue for risk management.
With the major players in the industry switching over to the FMCG model of Maximum Retail Price (MRP), managing inventories and the price risk to remain competitive has become more complex. In addition, directly importing their raw material requirements puts the large players in the twin risk of the international price and currency rate. For those which have covered their price position in the overseas cash market, the currency position still remains exposed. And this is where domestic currency futures provides them with a shot in the arm to stay protected. The same is the case with an export consignment (with a fixed price) made out of imported gold for whom the currency risk is simply a double whammy. Except the job-based diamond polishers located at designated export zones, other diamond polishers who export imported raw diamonds would also benefit immensely from participation in domestic currency futures.
Irrespective of the sources of their raw materials and the markets for their output, the coexistence of or the simultaneous use of commodity and currency derivative contracts would prove to be the best way for the gems & jewellery firms to protect their market-based risks and remain competitive. And this would help the industry contribute its bit to the growth of an already vibrant economy.
The authors are are chief economist and senior analyst, respectively, at the Multi Commodity Exchange of India Ltd, Mumbai.These views are personal