Investors can benefit by understanding corporates’ forex hedging risks.
The July-September 2011 quarterly corporate results confirm that the RBI’s tight money policy has sliced margins. A sample of over 1400 listed companies tracked by the BS Research Bureau paid out over 13 percent of their aggregate sales as interest costs, up from 10.7 per cent in the corresponding previous quarter of 2010-11. The net profit margin for this set of corporates amounted to just over 8 percent, down by over 300 basis points from 12 months ago.
When financing is this expensive, and the net margin so low, it is difficult for businesses to survive. In a competitive economy, few businesses have much pricing power. A simple rule of thumb is to assume wholesale price inflation is a proxy for cost increases for manufacturers, and consumer price inflation is a proxy for the pricing power of industry. WPI and CPI are running at around the same rates, which means India Inc. has no pricing power.
If the RBI continues to hike rates, a larger number of companies will start reporting losses in the near future. There is also a real chance that consumption demand, which is reasonable so far, will slow drastically.
A couple of other trends were less obvious but could also assume significant proportions. Around 70 corporates in that set reported significant forex losses in a quarter when the rupee slid sharply. These were presumably, under-hedged (assuming less volatility than actually occurred), or misjudged direction.
As of now, forex losses are negligible in aggregate, amounting to perhaps 0.5 per cent of turnover for the sample. But in specific cases, forex losses were massive. Arvind for example, wrote off 18 per cent of sales on account of forex losses, while Subex and Sesa Goa took 30 per cent hits each. JSW Steel lost 6.5 per cent. As more Indian businesses develop transnational aspirations and links, the need to hedge currency exposures will increase across the board. If India Inc. doesn’t improve competencies in this area, serious issues may arise across the board.
Dozens of Indian corporates are also sitting on external commercial borrowings (ECB) that could become potential timebombs if depreciation is mishandled. The nominal interest rate differentials between rupee rates and Euro, USD or Yen are very substantial and growing, due to divergent central bank policies among other reasons. This makes ECBs attractive instruments. But a corporate that must service overseas debt with rupee earnings has to be able to cope with rapid depreciation. From the perspective of any Indian business, and hence Indian investors, the RBI attitude will have a binary impact. Further rate hikes will hurt, while rate cuts would be beneficial. It’s more difficult to assess the impact of further rupee depreciation for it does help exports.
But the outstanding ECBs, and the apparent inability of many corporates to manage depreciation scenarios, means that further depreciation could cause more harm than good. Of course, there are no guarantees that rupee strengthening would be hedged any more competently than depreciation. But it would reduce the threat of ballooning external debt.
How can an investor make a call on which corporates manage potential treasury issues better? It’s difficult even in the most stringent reporting regimes to assess this sort of risk and many instruments can lead to off-balance sheet, unreported risks. In India, there is little if any data on which to base any judgement. One problem with diagnosis is that many forex hedge strategies are zero sum. Given continued volatility, corporates that have recognised losses in one quarter may well recognise equally large gains in the next!
Another problem is that many CEOs and corporate boards may lack innate understanding of the risks. Hedging forex is a black box situation for them as well. They may not even be aware how risky a given instrument is. So the traditional desi sources of insider information may not be helpful and insider info could be actively misleading.
There are aggressive corporate treasuries that try to generate profits on the forex front. There are conservative treasuries that look to just manage risks and ensure a degree of predictability to costs and profits. There are scenarios where one or the other approach works better.
Investors, who learn to look for signs of trouble on this front, are likely to do significantly better in the future, than the ones who don’t. Understanding forex exposure and risk is an under-rated skill in the Indian accounting environment. It may be worth investing some time and trouble in learning how to diagnose the dangers.
