Export is supposedly a high risk and high return business. While there is unanimity on risk part – question mark hangs over high return part as negative change in exchange rate may rob an exporter even after overcoming external risk factors such as credit risk. Unlike credit risk, which is an external factor and can be mitigated partly through insurance (please see earlier article on export risk mitigation ).– currency fluctuation is a domestic issue and completely outside the control of exporter or banks. It can make a product competitive or pricey, rob exporter of all gains from a successful overseas transaction or may make a long term supply contract completely unviable or uneconomic midway its execution.
Its necessary to understand extent of this threat and more importantly, how to manage the risks and available measures.
How Serious is The Threat of Currency Fluctuation
Currency fluctuation may not be considered as risk in countries with fixed exchange rate such as China , India till 1992 or those experiencing relatively stable exchange rate for years. However, in countries like India it’s a severe risk today as abrupt evaluation or devaluation of exchange rate may make an exporter pauper or richer. Let us chart the course of rupee over last few years.
Indian rupee has seen sharp volatility since Financial Year (FY) 2008 due to substantial FII inflow/outflow. The rupee appreciated to 39.4 per dollar in January ’08 compared to 44.00 a dollar in March ’07. After appreciating for almost 16 months, the rupee started depreciating and fell to an all time low of 51.2 a dollar in March ’09, due to FII outflows. However, the strong recovery of the economy followed by robust FII inflows in the equity market has once again led to a sharp appreciation of rupee in October ’10. The fluctuations have become so sharp since 2007 that apex body of exporters, Federation of Indian Exporters Association has suggested full convertibility of Rupee. In his first interaction with the Capital’s media since he took over as FIEO chief late last month, Mr Ramu Deora expressed concern saying its good neither for exporters nor importers but only helps speculators, and suggested full convertibility of the rupee to tackle high volatility in the exchange rate.
Why Exchange Rates Fluctuates ?
Let us see underlying reasons for change in exchange rates between Rupee and US Dollar and attempt to correlate to present situation.
Appreciation or depreciation of Rupee against the dollar depends mainly on demand and supply equation between both the currencies. If the demand for rupee is comparatively higher, rupee appreciates; if low, it depreciates. The factors that drive the demand supply for a particular currency are:
- Interest Rate: A demand for a currency is hugely dependent on the interest rate differential between two countries. A country like India where int. rate is around 7-8% experiences greater capital inflow as investors get better return than what they might get in US. (with Interest rates of 2-3%). This results into rupee appreciation.
- Rate of Inflation: The demand for a country’s goods & services by the foreign buyers would be more if the inflation rate is lower in that country compared to other countries. Higher demand for goods & services would mean higher demand for that currency resulting in the appreciation of that currency. For instance if India’s inflation rate is lower than that of Zimbabwe then the demand for our goods, services and currency would be higher than that for Zimbabwe’s.
- Export-Import: If a country is exporting more than its imports from other countries, then this would mean higher demand for that currency, causing appreciation of that currency against others.
- Trading in currencies in the Forex market: The exchange rate fluctuates minute by minute because of speculative trading in the Forex market.
Impact of Currency Fluctuation
- Impact on economy: Exchange rate fluctuation has a significant impact on the overall economy of a country. Rupee appreciation against US dollar is an indication of the strengthening of Indian economy with respect to US economy.
- Impact on foreign investors: If a foreign investor invests in Indian stock market and even if its value doesn’t change in 1 year, he’ll earn profit if rupee appreciates and make a loss if it depreciates. You can understand this with an example:
- Suppose an FII Invests Re. 1 Cr. in the Indian stock market and at an exchange rate of $1 = Rs. 50. So, the amount invested is $200,000.
- Suppose, after 1 year, even if the value of investment doesn’t appreciate the foreign investor can earn a profit if the exchange rate has changed to $1 = Rs. 40 (Rupee appreciation)
- If the investor sells his investment and converts the currency, he would get $ 250,000. So, he would earn $ 50,000 as a profit thanks to a change in the exchange rate i.e. rupee appreciation
- So, a continuously appreciating rupee would lead to greater investment by the FIIs.
- Impact on industry/companies: Appreciation of the rupee makes imports cheaper and exports expensive. So, it can spell good news for companies who rely on import of goods like heavy machinery, technology, micro chips etc. According to reports by Associated Chambers of Commerce and Industry of India (ASSOCHAM) sectors like Petro & Petro Products, Drugs & Pharma and Engineering Goods which have import inputs of as much as 77%, 19% and 21% respectively would stand to gain the most if rupee appreciates. They would have to pay less for the imported raw materials which would increase their profit margins.
- Similarly, a depreciating rupee makes exports cheaper and imports expensive. So, it is welcome news for sectors like IT, Textiles, Hotel & Tourism etc. which generates revenue mainly from exporting their products or services. Rupee depreciation makes Indian goods & services cheaper for the foreign buyers thus leading to increase in demand and higher revenue generation. The foreign tourist would find it cheaper to come to India thus increasing the business of hotel, tours & travel companies.
How to Manage Currency Fluctuation Risk ?
Rupee appreciation affects all exporters – however, SMEs are likely to suffer more as large businesses can soften the impact of rupee appreciation on their earnings by hedging their export contracts in the forward market. SMEs, in contrast, are the worst hit, as their export contracts are generally not hedged. This reduces the export realisation of SMEs, which would affect their bottom line if the loss from the foreign currency transaction is not passed on completely to the customer.
To manage foreign exchange risks, SMEs can opt for either selective hedging or systematic hedging. In selective hedging, SMEs that have significant but short-term exposure to foreign currency can hedge a part of their total exposure and can make a gain or loss from the unhedged portion. Selective hedging is also done when there are expectations of a favourable movement in exchange rate at the future date. In systematic hedging, SMEs can hedge their entire export contracts. SME exporters can reduce their exchange rate risk through currency diversification, forward contracts, swaps and call and put options.
In India, dollar-rupee futures are traded on three recognised exchanges, namely NSE, BSE and MCX. Further, an RBI notification on January 19, 2010 has permitted direct hedging of currency risk in other currency pairs like euro-rupee, Japanese yen-rupee and pound sterling-rupee. The introduction of new currency pairs in the currency futures market would help market participants to hedge against cross-currency volatility and mitigate exchange rate risk across all major traded currencies. Moreover, currency futures are traded at transparent, market-determined rates that are available to all market participants. Besides, market participants do not require to have an underlying exposure in foreign currency. Currency futures have the advantages of easy accessibility, easy affordability, low transaction costs, transparency and efficient price discovery.
Despite the availability of new hedging avenues, a very small number of SMEs enter into currency futures transactions to hedge their risk. This can partly be attributed to the small size of their international business, because of which SMEs usually do not get the best deal from OTC forward desks of banks or primary dealers to hedge their risk. Besides, the quotes offered to SMEs are at a higher premium. Also, various misconceptions and the lack of awareness amongst SME exporters about currency hedging hold back SME exporters from the currency futures market.Given the strong fundamentals of the economy, coupled with the widened interest rate differential between India and other developed economies, FII inflows are expected to remain robust in the coming months, leading to further appreciation of the rupee. Hence, there is a greater need for SMEs to have an effective and smart strategy in place to mitigate the exchange rate risk. Further, it is essential for small units to evaluate their cash flow positions and assess the degree of influence of exchange rate fluctuations on their profitability. Also, before sealing an exports deal with an overseas client, SMEs should keep the option of entering into a price variance with their customer, based on exchange rate fluctuations.