Market Maniac

Enjoying the Rajan put
Jul 30, 2015

About a year ago or so, I was visiting with a senior RBI officer who mentioned “the Rajan put” in passing. It was the first time I had heard the term, which – just like the Greenspan put and the Bernancket put – meant the apparently free option provided by RBI under which entities with short dollar exposures (importers, companies with FX borrowings) could be reasonably comfortable staying unhedged since RBI was moving heaven and earth to ensure that the rupee didn’t depreciate sharply, or certainly nowhere close to the cost of forward cover.

I was amused by this description, since, at the same time, a whole host of RBI officials from Dr. Rajan through Deputy Governor Khan on down kept warning companies that they should hedge their short FX exposures, clearly an approach in conflict with RBI’s operating policy. While I have always felt – and had articulated as much – that it is not RBI’s job to tell companies how to manage their affairs (provided they followed regulations), it was certainly within RBI’s authority to get banks to charge customers for the additional risk they were carrying on unhedged exposures, which, finally, it did.

So, the status quo remains. RBI remains extremely aggressive in the market – much more so than it (or any other central bank) has ever been – buying and selling dollars daily to ensure that the rupee remains very tightly range-bound, accumulating reserves at a good pace. On the other side, companies with FX borrowings (and, indeed, many with imports) are enjoying the Rajan put and staying largely unhedged, in the belief that even if there is a sudden wobble, the gains on hedging cost over the months/years will off-set the occasional dramatic loss the open position would suffer as in April and July 2011, January and April 2013 and then again in July 2014, when the average cost of an open position exceeded 25% per annum.

While it makes perfect sense to us to never look a gift horse in the mouth and ride the Rajan put, it doesn’t make sense to depend on it entirely. Markets are markets and Rajan put or no Rajan put, there will be events that can spiral out of control. To address this situation, we put on our research caps and have developed (yet) a(nother) structured hedging program that performs brilliantly for import hedging.

Over the period April 2010 to June 2015, the program resulted in an average cost of 4.17% per annum for 6 month exposures; this was more than 1.5% better than hedging on day 1 and nearly 1% better than staying unhedged.

Applying a modified version of the program to ECB’s, we found that the average amortization cost for a 5-year ECB was 4.35% (for loans ending between March 2014 and June 2015); this was fully 1.5% per annum better than the average POS cost of 5.91%. Of course, since regulation prohibits booking and cancelling capital account exposures in the onshore market and since there isn’t adequate liquidity to term on the domestic futures exchanges, this approach can only be implemented in the NDF market. Of course, most companies with the wherewithal to borrow off-shore usually have global subsidiaries so this does not pose a problem, except that it limits the evolution of the domestic FX market.

Rather than flailing about worrying about the NDF market or whether the domestic futures market is serving the intended purpose of enabling small enterprises to hedge effectively – although, to be fair, these concerns do not appear immediately current – RBI should focus on what it needs to do to make the domestic OTC market genuinely useful to its constituents by eliminating unnecessary regulations, like the prohibition on booking and cancelling hedges taken on capital account exposures.

Another regulation that defeats the purpose of risk management is the prohibition of taking a derivative on a derivative; thus, if a company swaps a rupee loan into dollars – let’s say it has exports and would like to try and benefit from lower USD interest rates – it will not be permitted to close out the risk (or part of the risk) by buying a FRA or a forward. This seems perverse.

All of the above is very well known to RBI, but trying to reverse these – to me at least – counterproductive regulations end up in a Kafkaesque loop, as many who have approached RBI have learned. As a result, very few companies approach RBI even for clarifications; most end up finding alternate routes or, what is worse, constraining their own operations.

I have worked reasonably closely with RBI for nearly thirty years now, and, while I have tremendous respect for the intellectual capacity and integrity of most of the people I have met, I think a major limitation is the “institutional effect”. Perhaps, senior officers should be required to produce research papers with a thrust inimical to the views of the parent – e.g., “Why the registry and depository functions of public debt should be housed in the proposed Public Debt Agency instead of RBI”, or “Why the governor should not have a casting vote in the MPC.” Not that I am recommending either of these ideas; it’s just that the exercise would lead to a deeper understanding of different facets of all issues.

Educated flexibility is a key skill in regulation, as, indeed, it is in every aspect of life.



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