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Saturday, March 28, 2009

Currency exposure of Indian firms

Under a floating exchange rate, firms have a correct estimate of how risky it is to have unhedged foreign currency exposure. When a central bank artificially distorts currency volatility downwards, as RBI has often done, this gives out the wrong incentives to take on foreign currency risk. Now firms in India are lobbying that they be permitted to delay marking to market of exchange rate losses in the aftermath of a surprising rupee depreciation. Mahesh Vyas has facts on Indian firms and currency exposure, in the immediate context of the debate on fudging AS 11 disclosures. Also see editorials in Financial Express and Business Standard.


  1. If liabilities (such as FCCBs or ECBs) are required to be marked to market, then so should assets be (land, plant & machinery or investments). In an ideal world, we would like the balance sheet to reflect all the assets and liabilities at market value. But, that's an ideal world and we certainly do not live in one.

    We live in a world that derives its existence from two major principles: 1).historical cost basis (largely confined to the balance sheet) and 2).accrual basis (this is how income and expenses are booked in the P&L).

    The mark-to-market concept is something that belongs to the ideal world and is therefore a major cause for all the trouble (read - volatile movements) in the values of assets and liabilities. It's implications are being felt across the globe and not just in India, especially the financial institutions in the West whose capital requirements have gone for a toss because of m2m.

    To my mind, the solution to this is to not mix the two, i.e. m2m and historical/accrual basis. And, thus not have m2m (in any form, mandatory or optional) in the balance sheet, but as Mr.Vyas suggested have companies disclose them in detail (i.e. the terms and the effects had it been included in the B/S) in the notes to accounts, both at the quarter-end as well as the year-end.

  2. Ravi, the debate is not over m2m against historical costs. It is about the move to suspend the AS-11. It is about changing the rules of the game when they do not suit us.

    m2m is not the cause of trouble -- it is merely a measuring instrument that tells us how much is the trouble. the fever will not go away if we do not measure it. in the west they have problems because a) there is not much of a market to mark to and b) it is difficult to meet capital adequacy requirements arising out of mark to market.

    This is not the case in India.

    In India, by changing the rules, we are merely trying to hide the problem, hoping that in sometime, the fever will go away. More importantly, it opens the gates to manipulating the accounting rules to suit industry. It looks like a higher level of a scam -- from manipulating accounts to manipulating accounting rules!

    I am not getting into a debate of whether to mark to market or to use historical values. It is a valid debate that needs its own attention particularly since we are now set to adhere to the IFRS. This will raise issues on fair value accounting.

    The point I have made is that rules should not change to reflect what suits us, the interests of just a few companies should not determine the rules of the game and the role of accounting is to reflect the volatility of values and not to hide it.

  3. The previous comment is by Mahesh Vyas; blogger somehow didn't show his identity correctly.

  4. hi Mahesh sir,

    I agree. Rules should not be changed at our convenience. The implementation of AS11 made a lot of companies look like amateur currency market traders which is the problem (or fever as mentioned in ur reply) and impact of which is there for us to see, thanks to AS11.

    However, all I am trying to say is that accounting principles should be consistent in treating assets and liabilities. And, AS11 is an anomaly in that. We either move to the ideal world (m2m accounting & cash-based P&L accounting - personally i'd prefer this) or have consistency in treatment of assets and liabilities under the current rules.

    But, it is critically important that all forex transactions and their impact on the P&L as well as the B/S be reported in the Annual Report in detail (as a part of Notes to Accounts), just like contingent liabilities and funding status of pension obligations of companies are reported.

  5. are assuming that the entire amount of foreign loans are unhedged ....I think that the overall hedged amount should be at least 50% .

    though i agree totally with the overall theme.

  6. Dear Professor Shah
    Your profound knowledge of the subject is equally matched with an excellent expression. I welcome your reply with reference to Stochastic Models in Derivatives.

    Excellent Statistical Models cast a spell on me and leave me in awe (and so I feel others). However, none presents the numerical values for various parameters like 'theta' etc (not even the range for the parameters!) The data for Indian derivative markets is limited, extending back to about half a decade; no meaningful Econometric Study can be done with such limited data.
    I request your opinion of presentation of any numerical values for the parameters in the Developed Markets.
    I wish to say that Finance Researchers produce Papers for promotions and for gaining a good name (the most mathematical the paper is the better as it would indeed impress readers;no numerical values need be given for the plethora of parameters introduced into the model as that is anothers job.
    I request your critical reply (I am aware many may feel my blog is stupid)
    Best regards
    Dr. Poolla R.K. Murti

  7. Ajay, Mahesh,

    The FASB seems to be seeing a need for a mark-to-model; the model would be left to the judgment of the Board.

    More info here

    I appreciate the concern for having comparable figures and not changing rules, but would it not be cheaper, in the short run, to let corporates recast their asset valuations, rather than pump public money into them. Everyone feels happier that Citibank is flush with Tier 2 capital, the investors come back, the panic is over. And as a self-fulfilling prophecy, if we all use the same model, who is to say it is wrong, anyway?

    In the long run, of course, we are all dead; but that is another story.


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