The spectre of being wiped out of business looms large over many companies as they count their losses on account of forex derivative positions held by them. Volatile currency movements over the last few months have meant that companies across the board, from small to large, have suffered thanks to derivative positions held by them, which is a tool used for both hedging and trading their underlying currency exposure.
Typically companies who deal in foreign exchange, mainly exporters and importers, hedge their underlying exposure. But the smart ones go a step ahead ? they also trade their underlying exposure to book profits. This is done with the help of structured instruments sold by banks. ?RBI rules stipulate that corporates cannot be a net receiver of premium,? says Chiragra Chakravarty, principal consultant, Pricewaterhouse Coopers. ?To ensure that RBI rules are not flouted, banks and corporates sell options to each other and the premium charged is netted off to make it zero-cost.?
What complicates matters is that banks have very exotic products on offer to hedge and trade risk. Companies with no proper understanding of it could get trapped. At least that is what happened in the current case.
Prior to the sub-prime crisis in the US, which reared its ugly head in the second half of last year, most companies were making substantial profit on structured derivative transactions on account of the dollar being strong against currencies such as the Swiss franc and Japanese yen. Says NS Venkatesh, managing director and chief executive officer, IDBI Gilts, ?For almost three/ four years, the Swiss franc to a dollar stood at 1.20 CHF, never going beyond this mark. Even the yen to a dollar was pretty strong at 110.?
Following the default rate going up substantially in the sub-prime mortgage market in the US resulting in a number of key banks reporting huge losses, the dollar already weak against the Indian rupee, became equally weak against other international currencies including the Swiss franc and Japanese yen. This meant that companies who held large positions in derivatives of these currencies were not able to book the profits they had anticipated. Instead they had a loss on hand. Says a banker on condition of anonymity, ?What took everybody by surprise was the speed with which it unfolded.?
The most affected of the lot were small and medium enterprises who do not have a full-fledged treasury department to track currency movements or mark-to-market losses or gains on their positions on a daily basis. Many of them went by what the banks were telling them when the latter were selling exotic products to them. ?Though the ultimate responsibility of taking up the product rests on the company, one cannot deny the role of the banks in pushing them on to the latter,? says K Rajaram, head of forex, treasury and risk management at Arvind Mills.
To add to the misery, companies were asked by the Institute of Chartered Accountants of India (ICAI) in March this year to account for derivative transactions in their financial statements. This has been described as a forerunner to the new AS-30 norms to be introduced in 2011 by the body. Among other things, the AS-30 norms speak of providing for all losses by a company in its books of account.
By some estimates the overall mark-to-market losses suffered by companies due to forex derivative positions held by them varies from anywhere between $1.5 billion to about $5 billion. But the figure of $1.5 billion is closer home, say a few experts. ?I think $4-5 billion is a bit exaggerated,? says a company executive. Nandlal Bhatkar, chief executive officer of the Pune-based Pyxis Systems, which provides software, training and consulting on derivative issues to banks, reiterates this point.
?There are some 8-10 banks who are into forex derivatives in the country. I don?t think the mark-to-market losses would be over $1.5 billion.?
Though a mark-to-market loss is a notional loss, the big issue for banks is when companies don?t pay up for positions held by them. That is a credit loss, which is serious from a bank?s point of view. Already a few companies such as Rajshree Sugars & Chemicals and Sundaram Brake Linings in the south have said that they will not pay up on certain transactions, which they claim were missold to them by their banks. They have dragged their banks to court on that matter. ?There are more companies waiting in the wings to do the same. I think they are trying to determine whether litigation is the best option given the spate of suits that have been filed at the moment. They would be waiting for the outcome,? says a banker based in Mumbai.
As the full extent of the notional loss sinks in, the Reserve Bank of India (RBI) has stepped in to try and bring some order to the forex derivative business ? which is an off-balance sheet exposure for banks. The apex body has stated its desire to review guidelines concerning off-balance sheet exposures of banks. At the moment there is no volume limit on the exposure that banks can take on derivative transactions. It is determined indirectly by capital adequacy norms with contracts upto six months having no limit at all, while contracts from six months to a year have a conversion factor of 2.5% and a capital adequacy of 9% etc. As the period goes up by a year, the conversion factor also increases by a percentage point. Capital adequacy in contrast remains constant. RBI proposes to review this conversion factor as also risk weights on derivative transactions.
Guidelines for the same are likely to be out by May 15, says the apex bank in itsrecently announced credit policy. This should quell the storm a bit, which has been raging for some time now. By some estimates, Corporate India should take about a year or two to clean up the mess on account of derivative transactions that have gone wrong. These are companies capable of wiping out the losses from their books, but for those who cannot do it, it is a lesson learnt a bit too late.