Forex Swaps Make a Cautious Comeback

Betting on stable rupee and low interest rates in US, corporates swap costly rupee loans for cheaper dollar debt

SUGATA GHOSH MUMBAI 

In the summer of 2007, when the euro and Swiss franc surged against the dollar, many Indian firms — small exporters ignorant of financial markets as well as large corporates with sophisticated treasuries — were badly bruised as their currency derivative bets backfired. Companies raised a hue and cry, banks went on the back foot, disputes reached courts, and later, the regulator changed rules to kill the market for exotic derivatives. After a long lull, currency derivatives are now slowly making a comeback, albeit on a cautious note and with plainvanilla offerings. 
Hit by high lending rates and lower earnings, many companies are taking a different bet this time. Based on calls that the rupee will not slip further and the dollar interest rate will remain low for some years, they are swapping their expensive rupee loans for dollar liabilities. It's a transaction that can lower interest costs and prop up profits. The risk, however, is that if the rupee depreciates fast enough, gains from the lower interest rate will be more than wiped out. 
"In the last few months, about 50 companies have entered into such derivative contracts. But this time, the documentation is stringent and all deals are authorised by the clients' boards," said a senior banker. "It's fine for a company with export earnings. If the dollar gains, your gain from exports compensates for the loss in the swap. But not everyone doing such deals are exporters," he said. 
The reduction in interest costs that the deals offer can be tempting to a company, particularly if its margins are under pressure. For instance, a company paying 12% interest on a rupee loan can lower the cost to less than 7% by doing a rupee-to-dollar swap. Current Swaps are Simple Structures 
With six-month dollar interest at less than 1%, the company will pay about 7% — a spread or mark-up of 6% on the 1% interest — to the bank with which it cuts the swap deal. The bank, in turn, pays 12% —the interest on the rupee loan that has been swapped. The difference, of as much as 5%, is what the company saves on interest cost every year. 
But if the rupee slides more than 5%, the company loses money on the deal. "The rupee has weakened 20% in last one year. It may be natural for some CFOs to think that the worst is over. But these are uncertain times. What if there is a downgrade?" said a foreign exchange dealer. "A few of such contracts were signed earlier when the rupee was gaining. Now, more companies are attracted to currency swaps as they look for ways to show higher earnings," he said. On Wednesday, the domestic currency hit a new closing low of 56.14, down from the previous closing of 55.97 to a dollar. 
Companies will be exposed to mark-to-market accounting losses on swap deals if the dollar rises. Accounting rules allow a company to avert mark-to-market hit by adopting hedge accounting, which requires detailed documentation. But in these deals, even those with export income cannot show the swap as a hedge to avert a possible mark-to-market knock on their profit/loss account. However, the present swaps are simple structures, and not comparable to the complex cross-currency products of 2006-07. Risks were higher then as companies had entered into rupee-toyen and rupee-to-Swiss franc swaps, betting that the yen and Swiss franc would fall against the dollar. A rupeeyen transaction meant factoring in movements in the rupee-dollar and dollar-yen market, which accentuated the risks. 
sugata.ghosh@timesgroup.com