Corporate May 28, 2012
No doubt the question on every chief financial officer's mind is should he/she hedge his/her forex positions when the rupee is at 55 to the US dollar?
Currency speculators will also be wondering whether to go long the dollar-rupee pair on declines or short at current levels. Sentimentally, it is a difficult question to answer as the sharp decline in the rupee, which has fallen close to 9 percent in the financial year to date, has given rise to expectations of further weakness in the currency. Global worries on the back of Greece exiting the eurozone and domestic worries over the current account deficit and policy issues are also adding to those fears, and it will be a brave man who can go against sentiment at present.
Greece is going for a second round of polls in mid-June 2012 and if hardliners who are calling for a euro exit come to power, it could lead to a fresh round of market volatility. India's current account deficit, at 3.6 percent of GDP for 2011-12, unless financed by capital flows will lead to more pressure on the rupee. Capital flows have been negative in the current financial year with foreign institutional investors being net sellers in debt and equity of $1 billion. There are also worries of short term debt of residual maturity of around $143 billion (accounting for 43 percent of the total debt of $335 billion at the end of December 2012) will not be rolled over.
Has the current level of the rupee factored in all the negatives or is there still more downside left? One must remember currency markets are 90 percent speculation and 10 percent actual flows. Speculators go with the sentiments and when sentiments are weak as are now, speculators would rather short the rupee than go long on it. The same is the case when sentiments are positive and speculators would prefer to go long on the rupee than short it. Hence markets at 55 to the dollar are short (despite speculative curbs placed by the RBI), while markets at 44 to the dollar are usually long indicating positive sentiments prevailing at that time.
Speculators and company officials need to ask themselves how much of the fundamentals have been factored in at 55 to the dollar? The negatives mentioned are out there in the prices but have the markets overrun themselves in discounting the negatives by taking down the rupee by over 22 percent from levels seen in 2011? Given the speculative nature of currency markets, it is probable that the level of the rupee at 55 to the dollar factors in more negatives than necessary.
India, despite its current account deficit, is not a heavily indebted country with its foreign exchange reserves largely able to sustain its levels of debt. Foreign exchange reserves at $290 billion are equivalent to 88 percent of total debt, enough for over seven months of imports including interest payments.
Keeping aside overall sentiment, India's external debt is not in any kind of bubble territory, and the country is unlikely to witness a run on its currency due to its external debt level.
Portfolio outflows have not been alarming enough to warrant the steep fall in the rupee. FII outflows were at just $1 billion from April 2012 to date, while foreign fund inflows in the calendar year to date totalled $10 billion. The rupee is front-running FII selling, which may not happen on a large scale given that levels of all asset classes including equity have slumped.
The interest rate differentials support the rupee, with the difference between three month dollar libor at 0.5 percent and three-month treasury bills at 8.4 percent. The high rate differentials factor in hedging costs (credit spread plus currency hedge) and hedging costs reflect market sentiments rather than pure fundamentals. The wide differentials encourage debt flows, though in the short term, flows will be weak due to negative sentiment.
The cost of hedging by paying three-month or six-month forward rates of 7 percent and 6 percent annualised, respectively, is high enough to deter hedgers. The rupee option implied volatility at 12 percent levels makes hedging using options expensive.
Importers (who require to buy dollars) will have to have a firm view that the rupee is going down further by at least another 5 percent to hedge.
Exporters (who require to sell dollars), on the other hand, will tend to leave positions unhedged as they have seen their earlier hedges at around 50 to the dollar go deeply out of the money. However, they also must believe that the rupee will go down further to leave positions unhedged. In fact, exporters should actively look to hedge their positions, as levels are attractive enough for going long on the rupee.
Speculators will do better taking off directional one-way bets on the rupee. Movements could be volatile especially if Greece votes to stay in the eurozone. However, long rupee bets have to be tempered given current market sentiments.
Arjun Parthasarathy is the editor of www.investorsareidiots.com, a web site for investors.
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