Companies should hedge at least 63% of ECB exposure: RBI paper

All category of borrowers are not mandated 100 per cent hedging, though banks are ” In times of typical high forex volatility, firms issuing ECBs may take recourse to hedge their exposure financially/naturally in the range of 63 per cent- 66 per cent, which would translate to the total cost on loan, including hedging cost, proportional to nearly 9 per cent. Moreover, this strategy is likely to lead to protection against forex risk” said a research paper by Ranjeev, assistant director at the Reserve Bank’s department of statistics and information management.

The study assumes significance as the rupee is expected to weaken with Fed tightening and surge in dollar demand as crude and commodity prices surge. “Hedging all FX exposures in their entirety may not be optimal in the sense that with fully hedged FX exposure, the benefit of low-cost access to foreign capital is foregone and at the same time unhedged foreign currency exposures may lead to correlated defaults in debt servicing triggering build-up of systemic risk” the author said.

External commercial borrowings at $219 billion comprise a third of India’s external debt as of September’2021. But there are no estimates of the level of hedging as there are rules that are sector specific or tenor specific. The existing rules prescribe mandatory hedging for specific sectors like Infrastructure firms with only rupee revenues, in terms of tenor, it is mostly for loans upto five years. Long-term ECBs with an average maturity of more than 5 years need not be hedged.

Many other corporates, though not mandated by the ECB guidelines, are taking up financial hedging voluntarily where the decision to hedge depends on the broad risk management decisions of the Board. Besides, the hedging decision depends on the depth of the domestic foreign exchange market, the presence of natural hedges/economic hedges among other factors.

Yet, a research paper by Reserve Bank of India economists underscore the need for an optimal hedge ratio is a ratio – the percentage of total asset or liability exposure that an entity ought to hedge against exchange rate fluctuations.

Though policy makers would think it is prudent to hedge all foreign exchange exposure, the borrowing corporate may think other- wise. ” Corporates undertaking hedging contracts for their forex exposure would be looking for a trade-off between hedging cost and forex risk” the authors say. ” This is because, in times of high volatility, as was the case during the taper tantrum in 2013, hedging costs increases enormously and the tradeoff becomes more challenging” , the paper said.