Currency Swaps a hedging tool
Exchange rate variability is a major risk potential in cross-border transactions whether relating to trade or pertaining to financial exposures in different markets over a period of time. The concern about the disruptive consequences of such variations either in terms of real and financial angle are well reflected in the policy frame work of major economies globally to explicitly limit the nominal variability of their currency vis-à-vis that of others. The recent spurt in dollar value against rupee and the continuing volatility in trading is one such glaring example which has resulted in wider implications at the macroeconomic front. Though, the intervention of Reserve Bank of India (RBI) has temporarily arrested the falling trend, after hitting record low of Rs 68.85 per dollar on
28 August 2013 and now has recovered and it is hovering around Rs 62 per dollar. But, with rising dollar demand, it needs to be seen whether the actions taken are concrete to stand the test of time which will only unfold in the future.
In this case, some of the most impacted customers are state run oil marketing companies (OMCs). In order to bail them out, RBI has announced the opening of forex swap window to meet the daily dollar requirements of the three OMCs. Forex Swap is an arrangement in which two parties initially exchange precise amount of different currency and a series of interest payments on the initial cash flow. The basic arrangement is that one party will pay a fixed interest rate and the other will pay in floating rate although they might have alternatives of fixed – fixed or floating – floating rate deals. And at the expiry of the swap contract the principal are exchanged back. The advantages of participating in a currency swap measures is that of active currency hedging of exchange risk, as well as access to markets where cheaper funding can be sourced allowing a comparative advantage. Such swap arrangements may immediately take off the current requirements but with an average daily requirement of $300-$500 million and without generation of adequate export earnings by the OMCs will force RBI to roll back the swap deals. In addition to it, the problem lies in the added cost in hedging. Unless the dollars are returned to RBI they cannot be a part of the reserves which in turn will adversely affect the imports cover and country rating. Currency swap also carries counter party risk, if one of them does not fulfill its obligations the other party is left exposed. There are credit risk issues that tend to be much more complex, besides swap contracts can be quite expensive. Though such arrangements are practiced in Asian countries like South Korea, Japan and now even China has entered the fray with swaps agreements but the global experiences with swap contracts have not been that conducive, the subprime crisis and aftermath liquidation of Lehman Brothers. Further, the vulnerability of the rupee to global factors can take a decisive toll with clear indication coming from US Federal Reserve rolling back stimulus may halt liquidity inflow to emerging economies like India leading to fund reversals.
Secondly the lack of clarity in terms of contract tenure and modalities will only add to continued pressure. For the time being, the RBI is hailed for its action; however the banks are creating a bubble advocating the facility which will turn out to be detrimental in the long run to the Indian economy and the rupee. It should also be noted that in spite of creating a perfect derivative hedge, it can even lead to losses due to maturity gap, varying accounting practices as Indian accounting standards do not have a comprehensive accounting framework for such derivative contract. And last the obligations to ‘mark to market’ another grounds for asymmetry in accounts reporting.
The bottom line is that over exposures and dependency on swaps deals will slowly lead to systemic formation. With time ticking towards maturing the swap contract we need to see what will be Reserve Bank’s stance in the coming few days.
Ameet Banerjee is professor of finance, J K Business School
Raghuvir Singh is director general, J K Business School