Risk man­age­ment, a se­ri­ous busi­ness

The Pak Banker - - Front Page - C. R. L. Narasimhan

FOR banks and their cor­po­rate cus­tomers, man­age­ment of cur­rency and in­ter­est rate risks has al­ways been a daunt­ing but ab­so­lutely vi­tal task. It has be­come par­tic­u­larly chal­leng­ing to­day. The global fi­nan­cial cri­sis that be­gan in 2007 has vastly ex­ac­er­bated the mar­ket risks. There has been an ex­po­nen­tial in­crease in volatil­ity both in terms of di­men­sion and di­rec­tion in all classes of fi­nan­cial as­sets. In the new en­vi­ron­ment, in­sti­tu­tions - both fi­nan­cial and non-fi­nan­cial - have to reckon with move­ments of cur­rency and in­ter­est rates in ranges hith­erto not seen and cer­tainly not an­tic­i­pated. Al­most all the con­ven­tional and non-con­ven­tional meth­ods of con­tain­ing risks failed, some, as in the case of US hous­ing mar­ket, spec­tac­u­larly and with dis­as­trous con­se­quences for the en­tire world.

A very eru­dite speech on the topic "Manag­ing cur­rency and in­ter­est rate risks" was de­liv­ered by Harun R. Khan, Deputy Gover­nor of the Re­serve Bank of In­dia, at a sem­i­nar in Bom­bay re­cently.

Point­ing out how fi­nan­cial mar­ket risks af­fected the real econ­omy, he said that the big in­crease in volatil­ity had in­duced un­cer­tainty which, in turn, had a neg­a­tive im­pact on the real econ­omy as well. Fi­nan­cial and non-fi­nan­cial com­pa­nies, un­able to an­tic­i­pate their fu­ture, are adopt­ing a more cau- tious ap­proach to their busi­ness plan­ning and em­ploy­ment poli­cies.

It is un­likely that volatil­ity will sub­side any­time soon. In the postcri­sis pe­riod, the global econ­omy was ini­tially pro­pelled by the big de­vel­op­ing economies which more than off­set the lack­lus­tre per­for­mance of the ad­vanced economies. How­ever, the global slow­down has now caught with In­dia and China, too. The In­ter­na­tional Mone­tary Fund (IMF) is just one of the global in­sti­tu­tions to lower its fore­cast for the world econ­omy dur­ing the cur­rent year.

The slow­down has cre­ated un­cer­tainty, which, in turn, had to be coun­tered by some highly un­con­ven­tional mone­tary and fis­cal poli­cies in the ad­vanced economies. For in­stance, the ex­tremely loose mone­tary pol­icy fol­lowed by the Amer­i­can Fed­eral Re­serve, has the po­ten­tial to flood the global econ­omy with liq­uid­ity. That will have as yet un­known con­se­quences. Global com­mod­ity prices could go up, in turn, fuelling im­ported in­fla­tion in coun­tries such as In­dia.

On the other hand, In­dia might be able to tap global cap­i­tal flows to a larger ex­tent than now. How­ever, given the all-per­va­sive un­cer­tainty, cap­i­tal in­flows will also be volatile. This is al­ready hav­ing reper­cus­sions on the ex­change and money mar­kets in In­dia.

In­dia's grow­ing in­te­gra­tion with the rest of the world is an­other fac­tor. It is no longer pos­si­ble to shield the do­mes­tic econ­omy from the va­garies of the global econ­omy. Global risks are now eas­ily trans­mit­ted to the In­dian econ­omy through a va­ri­ety of routes - trade, fi­nance, com­mod­ity prices and con­fi­dence chan­nels. The end re­sult is al­ways height­ened volatil­ity.

The gov­ern­ment and the RBI have taken a num­ber of steps to help banks and cor­po­rates deal with the volatil­ity. Most of these aim to in­crease the sup­ply of dol­lars to hope­fully iron out fluc­tu­a­tions.

But this might be a case of be­ing ex­tremely short-sighted. For in­stance, the mea­sures to en­cour­age short-term ex­ter­nal debt flows will cause se­ri­ous fund­ing mis­matches if used for long-ges­ta­tion projects. They might also lead to a bal­loon­ing of debt re­pay­ments over the near-term. In that event, in­ter­est and ex­change rate risks will in­crease."

Mea­sures to aug­ment sup­ply of for­eign ex­change are one as­pect. But the RBI's cur­rent worry is two fold. (1) Many cor­po­rates are de­lib­er­ately or out of ig­no­rance not hedg­ing their for­eign cur­rency exposures. Ac­cord­ing to re­cent es­ti­mates, al­most 50 per cent of to­tal out­stand­ing exposures are un­hedged. This is an alarm­ing sit­u­a­tion. It can not only dev­as­tate the con­cerned com­pany's bal­ance-sheet but can pose ma­jor threats to the macro econ­omy.

(2) Closely re­lated are the sec­ond set of wor­ries which arise from the fact that many com­pa­nies are ex­ploit­ing the rules to spec­u­late rather than hedge. For some of these com­pa­nies, for­eign ex­change risk man­age­ment be­comes a 'profit cen­tre', akin to what­ever core busi­ness they have. In its most ba­sic form, exposures are left un­hedged, the ob­jec­tive be­ing to (hope­fully) profit from ex­change rate move­ments. Given the cur­rent volatil­ity, many of those hopes have come crash­ing down. Over the past few years, de­riv­a­tive in­stru­ments have been used for gen­er­at­ing profit rather than to mit­i­gate risks. In nearly all the cases, com­pa­nies, which gam­bled on ex­change rate, have come to grief.

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