Many years ago, when the rupee was constantly under threat to weaken, RBI often railed against speculators and, indeed, acted from time to time, for instance prohibiting domestic companies from rebooking cancelled forward contracts, since it was clear that some companies were—rather than managing their risk—simply speculating by buying (booking forward against imports) and selling (cancelling) dollars. Today, the shoe is on the other foot—with the rupee strong and constantly under threat to strengthen further—but RBI is surprisingly lax in its attack on on-shore speculators.
To be fair, RBI did try to impose some constraints on short dollar positions back in 2014, when the rupee had also been strengthening and there was a perceived threat that things could get better (worse?). It asked banks to increase their capital charges on rupee borrowings for companies who had unhedged net short dollar exposures. However, the impact was—and remains—relatively mild. In any event, I would argue against such a policy since different companies have different—and, sometimes, valid—reasons for keeping imports unhedged.
Instead, the focus should have been—and should currently be—on unhedged ECBs rather than all unhedged short positions. Fully hedged ECBs cost less than borrowing in rupees; so, keeping an ECB unhedged is clearly a speculative activity intended to benefit from the rupee’s possible appreciation. While, in general, I have nothing against speculation, but when it begins to create problems for the broader economy, the regulator should act. Not surprisingly, it is only large companies who take such positions—a 2016 study by Ila Patnaik and others found that the median size of a company who borrow overseas (Rs 550 cr) was 25 times that of companies that do not.
Of ECB users, a small number—mostly MNCs—hedge ECBs at inception; this is the soundest approach since a fully-hedged ECB is cheaper than borrowing in rupees. A much larger number of companies keep ECB’s unhedged because they believe they have a natural hedge through exports. This is often fallacious, since a medium-term FX liability (the borrowing) cannot be meaningfully hedged with a short-term FX asset (exports). While the “natural hedge” may work on a cash basis (although there are always timing mismatches), it results in either absurdly low borrowing costs with correspondingly low sales, and vice versa; this distorts the company’s accounts, leading to incorrect investor perception.
However, there are also a very large number of companies who keep ECB’s unhedged because they believe that the rupee will not fall by the cumulative forward premium over the term of the borrowing. And while this is not borne out statistically—over the last 10 years, the average five-year decline in the rupee was 19.8%, about on par with the five-year hedging cost—some speculative-minded companies have their beady eyes on the “best case”, which, over the same period has been a five-year rupee appreciation of 18%. Given recent rupee behaviour, this sentiment is obviously more in vogue, so the share of “speculatively” unhedged ECB’s is probably rising.
This, of course, reduces the natural demand for dollars, reinforcing the upward trend of the rupee, testing RBI’s tools to manage the market, and negatively affecting growth and jobs by reducing export competitiveness and pressurising domestic manufacturers who compete with imports.
To address this cleanly, RBI should directly target unhedged ECBs and require a significant—perhaps, as high as 50%—cash margin if companies wish to keep the exposure unhedged. Speculate if you will, but it will cost you. At even 8% borrowing cost, this would cost the company 4%, which is close enough to the premium to bring them—and the much needed dollar demand—to market.
While this instrument may appear blunt—using nukes to kill cockroaches, to quote a very smart ex-banker friend—and will certainly need to be tuned depending on how the rupee reacts, it is, in fact, very sharply targeted since it will only penalise those who are definitively speculating. Further, it doesn’t really hurt them—even when they do hedge, they will still make money since a fully-hedged ECB costs less than equivalent rupee borrowing costs. And while some may rail against this “excessive regulation”, we have all learned that there is no such thing as a totally deregulated market, and, importantly, the closer you get to laissez faire, the greater the risk of a systemic blow out.
Better to be prudent, and best to do so with a sharp focus.