Corporate India's fiscal 2009 results show that local companies have lost hundreds of millions of dollars from bad currency hedges—and in some instances this has wiped out their entire profit.
India's growing exports of services and, to a lesser extent, goods resulted in total export revenues of $155 billion in fiscal 2008, up 23% from the previous year. Exports earn foreign currency while expenses are in rupees, so companies resort to foreign exchange hedging to reduce the effect of FX volatility.
"It becomes important for the exporter to protect his margin at the time he recognises his revenue or incurs expenses, and thus be insulated from currency movements," said Bhriguraj Singh, head of trade and supply chain for HSBC in India.
The Indian rupee started 2007 at Rs44 to the dollar and steadily appreciated through the year to close at Rs39 to the dollar in December 2007. Most Indian exporters had not anticipated the rupee would strengthen by 11% across the course of the year and their bottom lines were adversely affected.
"We suggest our customers take a partial hedge on their export revenues, which provides some amount of upside while protecting against rupee appreciation," said Singh.
At the time it was the house view of many banks that the rupee would strengthen further against the dollar, to levels around Rs36 to Rs37.
Not surprisingly, given prevailing sentiment and professional advice, Indian companies aggressively hedged their future dollar cash flows on the assumption that the rupee would stay stable or strengthen. The idea that it could dramatically depreciate was not really on their radar screens.
By mid-2008 the rupee had fallen to Rs52 to the dollar—a drop of 40%. (It has recovered since and currently stands at levels around Rs48.) And, in a classic case of a double whammy, suddenly rupee depreciation was not the only problem facing these companies.
"The problems for Indian exporters were exacerbated when exports started slowing down," said Vipul Chandra, head of corporate sales and structuring at Citi. "These companies had hedged some percentage of their future receivables, based on projections for the business. Unfortunately, the crisis had the effect of causing orders to dry up such that even maintaining the past year's [order] levels became difficult, let alone [achieving] growth."
In May, India's exports stood at around $11 billion, down 29% in dollar terms on the same month in 2008.
"A gap across many Indian firms is the absence of a strategy to manage financial risks, especially in turbulent times like these," said Mukund Santhanam, managing director and co-founder of Aktrea Capital.
Santhanam and Rajiv Rajendra set up Singapore-based risk consulting firm Aktrea early this year. A combined experience of more than 25 years at global banks, most recently at Citi, made the duo realise the opportunity for a specialised risk management advisory firm.
"For many CEOs, managing risk means managing the underlying business; for CFOs, funding and accounting is the priority with risk management sub-consciously moving to the periphery," added Santhanam.
The technology trades
Firms operating in the information technology and outsourcing sectors were driven by the margin protection Singh referred to earlier, as more than 90% of their revenues are dollar-denominated. These companies were feeling vulnerable after the rupee appreciation they had witnessed in 2007 and, in response, aggressively hedged their future cash flows.
"Many technology companies used to hedge more than what was necessary, for longer periods than required and further, used riskier forward contracts rather than conservative option contracts," said Ankur Rudra, technology sector analyst at Anglo-Indian investment bank Noble Group.
Rudra cited software and IT services company HCL Technologies, which posted revenues of around $1.9 billion in 2008, as an example. After 2007 the Indian company "aggressively hedged its future cash flows by several multiples of quarterly revenues", he said. In a recent report on HCL, Rudra projected $193 million of foreign exchange losses over the next two years.
Despite the losses, Rudra has a buy recommendation on HCL and points out that it "reduced its hedges from $1.3 billion to $800 million in May 2009". Rudra also notes that most technology companies have started hedging positions for two or, at the most, three quarters, a period of time for which visibility is better.
"Given global uncertainties prevailing which make cash flow projections difficult, shorter duration hedges are preferable as they reduce the chances of being overhedged," agreed Chandra.
Technology companies factor their view on currencies into the contracts they bid for. Santhanam suggested that hedging multiple quarters of earnings using forwards is not necessarily riskier, because a good economic hedge does not always translate into a good hedge from an earnings perspective.
"Most IT companies mark-to-market multi-year FX forward contracts, in line with US accounting standards, while future inflows don't get recognised till the actual year when the contract is delivered," said Santhanam. "This may cause some volatility in the annual profit and loss account but, actually, future cash flows are more certain."
Upside and downside
The second category of companies had active treasury departments and years of non-rupee receivables, so assumed their in-house expertise to hedge currency exposure was adequate—especially because the products seem simple enough to understand.
"Most Indian companies don't generally buy exotic or fancy structures, rather it is forwards and vanilla options which are the norm," said HSBC's Singh. "They are also limited in what they can do by Reserve Bank of India guidelines."
But even with simple structures, the downside risk is high. In some instances these companies got emboldened by early profits on hedges to take excessive risk—as the treasury department showed profits on early trades, the limits on what they could do were enhanced. Some of these companies started buying products unrelated to their exposure.
"Companies can manage risk by reducing exposure or reducing volatility through diversification," said Citi's Chandra. "As long as diversification is done in limited amounts with the objective of reducing risk, it is a legitimate risk management strategy."
Some of the trades that caused pain for companies incorporated large amounts of leverage, either explicitly through over-hedging or implicitly through notional amounts that ballooned when the market moved against the customer.
"Losses on leveraged option trades for Indian companies is not as severe an issue as elsewhere in Asia -- notably the losses caused by a depreciating Korean won on some contracts entered into by Korean exporters," said Santhanam.
Ironically, it was the very regulation that is often criticised that constrained Indian companies and contained losses in most cases -- the fact that the Reserve Bank of India (RBI) does not allow exotic foreign exchange option strategies involving the Indian rupee. But some companies sought to get over this restriction by moving into other currencies where such restrictions do not apply, and the currency diversification may not always have been part of a clear-cut strategy.
Treasury departments started dabbling in currencies like Japanese yen and Swiss franc when all their receivables were in US dollars. Companies took exposure to these low-interest currencies to provide some protection against the adverse impact of rupee-dollar movements earlier felt in 2007.
"There was definitely some punting going on as companies got greedy," said a banker. "It was a classic bubble—as the traders made some money on the hedges, their limits were increased and before anyone realised what was happening, they were betting the balance sheet."
Small and medium-sized exporters, such as textile companies in South India, form the third cluster. Like the technology exporters, these firms had seen their export competitiveness eroded by the rupee movement in 2007. Hedging seemed like the solution to their woes. But some of these firms now say they had no understanding of what they were buying.
Who's to blame?/leadin>Foreign banks operating in India are clear that they don't sell products to companies which do not understand them.
"Our KYC [know your customer] procedures are well-established as this is a business we do all over the world—and have done historically," said HSBC's Singh. "We have mechanisms in place before we take on a client as a counterparty and also to ensure clients understand the risks associated with the products they buy."
Citi's Chandra also emphasised that suitability and appropriateness of customers is critical and is established before the US bank signs on clients.
A proliferation of local banks in India this decade and public sector banks eager to win business could be one reason why firms had little difficulty finding counterparties willing to sell them the hedges.
"Bankers would pitch exotic forex contracts to CFOs who had little historical experience with such complex instruments—CFOs would buy them without understanding the risks," said Noble's Rudra.
Indeed, some companies that lost money on hedges are pinning the blame for their past transgressions on the banks that sold them the products. While it is debatable who is to blame, the inexperience of some buyers entering these contracts is a problem.
Whoever is responsible, both buyers and sellers are now more cautious. "Bankers seem to have become more careful about what they market and, chastened by the events of the last 18 months, disillusioned CFOs are examining what they buy with an eagle eye," said Rudra.
Some Indian companies had become accustomed to relying on their consortium of banks to provide risk management expertise. But for most banks, risk advisory is a value-added service which is expected to yield further transactional business for the bank.
"Banks can have a conflict of interest as product bias can set in, making their objectivity a question," said one banker.
A further problem arises because treasury and risk management is not integrated across all banks. Many banks cater to the hedging and cash management requirements of their customers through different departments.
"Many Indian companies don't have corporate governance practices in place to enable their finance team to know what they can and cannot do," said a banker. Putting in place internal controls and setting trading limits, as well as creating committees which authorise such trades, are basics that some companies are now setting up.
Risk management consultants can also address some of these issues.
"The recent market volatility has made Indian firms sensitive to the vulnerability of their risk management practices and receptive to seeking advice from experts," said Santhanam. Aktrea's clients include banks (public sector as well as and private and local), non-banking finance companies, SMEs and even India-based multinationals seeking to manage risks arising from their global operations.
Aktrea's ongoing mandate from a medium-sized IT company highlights the complexities in developing effective hedging strategies. "We factor in underlying cost structures, competitive
positioning and the impact of market movements on the firm's financials," said Santhanam. "The hedging plan reduces the volatility of earnings caused by forex and provides confidence to the marketing team to win business."
Citi's Chandra drew attention to the need to view the entire issue of hedging losses in a broader framework. "It is important to remember most companies view hedges as cash flow management and not on a marked-to-market basis, the way analysts tend to view them," he said.
Generations of Indians saw the rupee move only in one direction, down, from around Rs3 to the dollar in 1948 to around Rs50 to the dollar in 2002. The appreciation thereafter seemed like it might herald a permanent change in direction, where the rupee would only strengthen. And that was the foundation of many of the hedges employed by Indian exporters. The recent volatility has been a timely reminder that currency movements are impacted by a host of factors, some country-specific and others which are almost impossible to predict or control. Currency hedging is only one component, albeit an integral one, of a risk management strategy.