Hidden derivative losses spook Indian investors

Investors in Yes Bank, an Indian lender partly owned by Rabobank Groep of the Netherlands, had a turbulent ride amid unraveling of corporate India's risky, leveraged bets on currency movements.

The shares of Yes Bank have tumbled 42 per cent this month, making it the worst performer among 18 banking stocks on Bombay Stock Exchange's Bankex index.

On March 19, the bank issued a statement rebutting what it said were "unfounded rumors'' it was losing money on foreign- currency derivatives exposure, or that customers "� similarly affected by losses on their own contracts "� were defaulting on their payables. Yes Bank has no uncovered positions in its foreign-exchange derivatives business and clients are meeting all their maturing financial obligations, the statement said.

What's important here is to ask why of all Indian lenders, Yes Bank "� rated a "buy'' by three brokerages in just the past two weeks "� bore the brunt of the sell-off.

The reason, as I see it, is simple: Yes Bank specialises in lending money to small and mid-sized businesses, which accounted for about two-fifths of the bank's total loans at the end of last quarter. Since the counterparty credit risk in derivative trades is perceived to be higher for smaller companies that lack the financial strength to meet an unforeseen commitment "� especially a derivatives loss magnified by leverage "� Yes Bank stock got pummeled.

Risk of defaults
Analysts at Mumbai-based brokerage India Infoline say the concerns about the bank and its customers are overblown: While Yes Bank's lending is directed toward smaller businesses, the foreign-currency dealings are with top companies.

"The bank clarified to us that none of its clients have defaulted so far and chances of material defaults are very unlikely since the bank has sold over 90 percent of derivative products to the top 200 companies in India,'' India Infoline analysts Prabodh Agrawal and Parthapratim Gupta noted in their March 19 report.

The fear of defaults is at the core of the current bout of anxiety in India with structured products. Anecdotal evidence suggests that the market risk of currency derivatives is primarily on the balance sheets of Indian companies, and not those of the banks.

But it isn't clear whether the smaller companies would be able "� or willing "� to meet their obligations to the banks.

Yen-dollar
Some media reports are already speculating if a contract involving a corporate treasury selling a currency option to a bank is enforceable.

After all, exporters and importers in India are only allowed to take forward currency positions to hedge their risk; they're prohibited from entering into deals where there's a net inflow of premium to them from selling options.

Those, however, are precisely the kind of trades many of them may have done over the past couple of years.

Jittery investors
Even so, as Mecklai noted in an interview posted on the Web site moneycontrol.com, Indian accounting norms don't require companies to mark these positions to market.

That means that bets that have turned unprofitable because of the US currency's recent slide "� to a record against the euro last week and to a 12-year low against the Japanese yen "� may remain hidden from scrutiny until the contracts mature and the losses are realized.

That's making investors in Indian companies jittery.

The shares of Wockhardt fell 3 per cent yesterday on a news report that it has chalked up "substantial'' paper losses because of positions in cross-currency options and structured products. The company denied the report in a statement yesterday and said it won't incur any losses on account of derivatives either in the current quarter or subsequently. Wockhardt's shares have slumped almost 25 per cent this month.

Not heeded
A panel appointed by the Indian central bank to take stock of the country's foreign-exchange market and recommend regulatory changes had anticipated in 2005 that in the absence of proper accounting standards, there will be "incentive for companies to engage in so-called 'cost-reduction' derivative transactions by hiding the associated risk.''

That warning shouldn't have gone unheeded.

Equity investors in India don't know which company managements have been adventurous in assuming currency risk.

The Indian central bank has instructed financial institutions to follow aspects of the international accounting standard that stands guard against underreporting of derivative risks. Non-bank companies in India can still get away with inadequate disclosure.

However, investors in Indian banks have an additional concern: credit risk. What if the thrill-seeking managements now become completely desperate and ask their counterparties in the mad, bad deals to take a walk?

(The author is a Bloomberg News columnist. The opinions expressed are his own.)