The year 2018 started with USD/INR at 63.80, the strongest it had been in several months; volatility was low at 4.5% and sentiment was for more rupee gains. By mid-year, however, oil prices crossed USD 75 per barrel, and the picture changed rapidly. India’s current account deficit and flailing exports came into focus, and the rupee began to slide. Volatility climbed steadily and by year-end has crossed 9%, the highest it has been in nearly five years.
The trauma of the past five or six months has left both exporters and importers exhausted and, in most cases, poorer, whether in cash or opportunity terms. The last time this happened was back in 2008, when USD/INR volatility shot even higher, peaking at nearly 17%. At the time, some companies got drawn into complex derivative transactions in search of easy profits and the blood on the streets took years to dry—indeed, there are a few companies still fighting legal battles with banks over that.
Many companies learned some hard lessons at the time, but most of them haven’t yet learned the hardest lesson of all —viz., do not try to judge the market, more so in periods of high volatility.
Given that the Fed and other developed country central banks appear committed to reducing the monetary accommodation that had defined markets for the past near-decade, it seems likely that global volatility in 2019 will be higher than in the previous few years. This could be exacerbated by Mr. Loose Cannon (aka US president Donald Trump), who has already triggered multiple episodes of volatility. With his travails certain to increase with the Democrats taking charge of the US House of Representatives in January, we could be in store for more boluses of madness, some of which may infect financial markets. And, of course, we have our domestic source of volatility, notably the general election in 2019. From a technical standpoint, too, it appears that volatility will remain high and/or increase going forward. Not only is spot volatility very high and climbing today, its 12-month average has crossed 6% for the first time since June 2016; the last time this happened, it persisted above 6% for nearly 4 years.
This means that risk management is going to be at least as—or, get even more—difficult than it has been over the past six months. More than ever, it is time to create a plan to batten down your hatches. In building the plan, it is also important to recognize that the forward premiums are down at about 4% pa; back in 2011-2015, premiums were much higher, averaging around 7.5% pa. The balance between premium earnings (or cost) and risk (which is volatility driven) needs to be carefully managed. The accompanying illustrates.
The first lesson (based on statistical history) is that there is a 43-56% probability that the rupee decline would be higher than the premiums, depending on the tenor of the risk. Also, the opportunity left on the table for exporters who hedge is huge—more than 10 rupees at 3 months and upto 20 rupees at 24 months. The opportunity left on the table for importers who hedge is lower but still quite substantial— more than 6 rupees across tenors. The risk to staying unhedged is the reverse—viz., much higher risk for importers but still high for exporters. Building in the risk (using VaR to a 95% confidence) indicates that for exporters, staying unhedged to longer tenors—say to 24, or even 12, months—provides a better return/risk ratio; incidentally, these numbers are much lower than they were in 2015, reflecting the sharply increased volatility. This indicates that export hedge tenors should be shortened and, in particular, companies who run ladders need to revisit their strategies.
For importers, the situation as always, is more difficult—while the average rupee decline has been higher than the hedging cost (except at 24 months, where they are more or less equal), suggesting the need to hedge, the fact remains that around 50% of the time, the decline has been lower than the premium. Again, the possibly opportunity gains are substantial—at 6 months, for instance, there is a 5% chance that the rupee could appreciate by more than 2.86, which, if captured, would bring funding cost to negative 8% (that’s minus 8%) pa!
Clearly, both exporters and importers need to build a disciplined sustainable process that enables both risk control and opportunity capture.
Here’s a good resolution for the new year: I won’t waste time thinking about markets or anything else I can’t control.
Happy New Year!
(The author is CEO, Mecklai Financial)