Monetary Policy and Economic Risk in India

3870 words (15 pages) Essay in Economics

23/09/19 Economics Reference this

Disclaimer: This work has been submitted by a student. This is not an example of the work produced by our Essay Writing Service. You can view samples of our professional work here.

Any opinions, findings, conclusions or recommendations expressed in this material are those of the authors and do not necessarily reflect the views of UK Essays.

Monetary Policy and Economic Risk in India 

Table of Contents

INTRODUCTION

RBI and Monetary policy

Quantitative tightening and repercussions for India

Operating in India – economic risks

How we can manage the risks? 


Tackling Transaction Exposure via Derivatives

Financial Hedging

Operational hedging

In summary

References

INTRODUCTION

In this era, more and more Indian firms and businesses are globalizing their operations resulting in more imports and exports. In the course of engaging with international firms, most of the firms will trade with multiple currencies. Consequently, these firms are exposed to foreign exchange risks and uncertainties in their bottom line due to unpredictable fluctuations in the exchange rate (Bhaskaran & Priyan, 2015). This report will firstly address the likelihood of the Reserve Bank of India (RBI) in taking a quantitative tightening (QT) approach as of now. Based on India’s current state of economy as well as a current repo rate of 6.5% that the RBI continued to maintain, the central bank may tighten the repo rate in the future. In the event that QT is actually imposed, the economic hypothetical ramifications will be investigated. The types of economic risks that MNCs face will then be explored. Such risks include direct and indirect economic exposure which branches out to transaction, operating and translation exposure. This is followed by a discussion on how such risks can be mitigated to survive the threat of ever-changing exchange rates.

RBI and Monetary policy

The RBI sets it monetary policy based on its medium-term expectations of Consumer Price Index (CPI) rates (RBI, 2018A). It operates a inflation range targeting strategy, aiming to keep CPI rates at 4 percent with a band of +/- 2 percent. Prior to the RBI’s monetary policy meeting in October, the RBI’s Monetary Policy Committee (MPC) had consecutively increased the repo rate in the past two meetings by 25 basis points each time. This placed market expectations that the RBI would become more hawkish with its policy, and most believed that the repo rate to further rise by 25 basis points (The Economic Times, 2018; Allirajan, 2018; MINT, 2018). Some Indian banks even preemptively increased their interest rates (Nayak, 2018). Expectations were fueled by the roaring fuel prices (Allirajan, 2018) with prospects of reaching $100 per barrel (Daily News & Analysis, 2018).  The Rupee against the dollar was also plummeting, reaching new lows as the Fed continued to increase its funds rate (Gupta, 2018; Parekh, 2018).

Against market expectations, the RBI decided to maintain the repo rate at 6.50 percent. In this case, the RBI was less aggressive than expected. Though oil prices weighted the MPC’s decisions, the Indian government had provided some relief by slightly cutting prices (Free Press Journal, 2018), therefore was not as significant a factor as market participants had believed. However, the MPC changed its stance on monetary policy from neutral to “calibrated tightening” (RBI, 2018B). This stance signals that there will be no rate cuts anytime soon, and rate rises on the horizon (The Hindu Business Line, 2018). The aggressiveness of these rises will be dependent on the macroeconomic conditions that compose CPI in the medium-term. Main factors to watch out for include oil prices, the falling Rupee, the Indian government’s fixing minimum support prices at 150 percent, and global market volatility. Thus far, with these factors taken into consideration, CPI forecasts have been revised down from the August resolution (RBI, 2018B), suggesting prospects that moderate intensity in policy changes.  

Quantitative tightening and repercussions for India

In the case of quantitative tightening, theoretically, increased interest rates could attract foreign investment. It could lead onto an increase in demand for the rupee and subsequently the currency’s appreciation. This could also potentially assist the Indian government recover from its widening current account deficit. However, against the recent Fed interest rate hikes (Free Press Journal, 2018; Sinha, 2018), this strategy may prove to be ineffective stirring much market investors’ interest towards the rupee. It may be the RBI’s best interest to learn a lesson from fellow emerging economies (i.e. Turkey, Argentina and Indonesia) that have failed to resolve their currency’s depreciation via rate hikes (Parekh, 2018).

The current decline in the rupee may prove to be beneficial to the exports sector. Having lower costs comparatively to trade partners and competitors, Indian products may become more competitive in the global market. As it stands, imports are rapidly growing and are likely to offset potential export gains (Bhandari, 2018). If a rate hike does lead to the appreciation of the rupee, the balance of payments is only likely to worsen.

Moreover, quantitative tightening from the RBI is inappropriate given the liquidity stress that the Indian market is currently experiencing. There is trouble in India’s shadow banking industry. A further drain on the liquidity through rate hikes will do nothing to ease the pressures of the collapse of IL&FS (an Indian infrastructure development and finance company). The government has already had to bail out IL&FS (Shukla, 2018), and the RBI scheduled to take on open market operations to relieve the situation with 360 billion rupees (The Hindu Business Line, 2018; MINT, 2018). The current account deficit may be a pressing issue for the RBI and Indian Government. But if the liquidity situation worsens, the government bodies will be forced to intervene even more in the market, and thus further widen the account deficit.  A tightening of policy would also negate the support provided to borrowers via the relaxation in statutory liquidity requirements (The Hindu Business Line, 2018). 

Operating in India – economic risks

Risks, in general, refer to the variation in business outcomes and performance to forecasts (Miller, 1992). Businesses that operate only in the domestic market face risks such as market risk, liquidity risk, and credit/default risk faced. On top of these common risks, businesses that operate on an international scale also face foreign exchange risk which comprises of operating exposure, transaction exposure and translation exposure (Eiteman, Stonehill, & Moffett, 2015). Companies are influenced by economic risks if the present value of its future cash flows are sensitive to changes in exchange rates (Marston, 2001). Companies that partake in globalised markets are susceptible to changes in the value of the domestic or foreign currency however the effects of economic exposure are not restricted to a particular industry (Marston, 2001). Since, this company operates in multiple countries, our overall exposure to fluctuating exchange rates is lessened.

There are two categories of economic risk known as direct economic exposure and indirect economic exposure (Eiteman et al., 2015). Direct economic exposure affects organisations if they are involved in foreign currency transactions or expecting to have foreign currency transactions in the future (Eiteman et al., 2015). Specifically known as transaction exposure it refers to the variability in a firm’s foreign currency denominated transactions due to exchange rate risk (Martin & Mauer, 2003). Given our company operates on a multinational scale, we are subject to changes in the repo rates that occur between the issuance and settlement dates of our transaction contracts (Martin & Mauer, 2003). Such movements can be either favourable or unfavourable. The potential increases in the repo rate, signalled by the RBI’s calibrated tightening stance, may increase the cost of our long-term borrowings. However, the RBI maintenance of the repo rate 6.50 percent till the next MPC bi-monthly meeting means that our current short-term borrowings (one to two months) will remain mostly unaffected.

Another direct risk affecting our transactions is the value of the rupee. The current depreciation of the Rupee makes our foreign account payables (or imports) more expensive and the increases the value of our foreign account receivables (or exports) (Bhakaran & Priyan, 2015).

On the other hand, indirect economic exposure occurs when a company’s competitiveness is affected by fluctuations in exchange rate (Eiteman et al., 2015). If comparatively, our costs are less than those of competitors because of lower exchange rate against trade partners, our competitive edge in the market strengthens. With the continuing surge in oil prices, Mishra & Debasish (2017) would conclude a continued downwards pressure on the rupee. This may be indicative of our potential to remain competitive by continuing operations in India. On the outlook, our sales margins should be relatively secure because of this competitive position.

How we can manage the risks? 


In this section, a few risk management strategies are suggested. These strategies aim to reduce the company’s exposure to transaction exposure, operating exposure and translation exposure.

Tackling Transaction Exposure via Derivatives

Transaction exposure is one of the more observable forms of exchange rate risk. Hedging by using forwards, futures or option contracts allows us to offset the changes in value of an existing position and thus minimise, or eliminate, risk (Antoci, 2015).

Figure 1 NCF from hedged position versus unhedged position (Antoci, 2015)

This approach is favourable as it adds more certainty to expected cash flow increases the firm value. (Figure 1) It releases companies from cash constraints and saves agency costs. As can be seen in Figure 3, many other Indian MNCs adopt multiple hedging techniques as risk management strategies.  

Figure 2 Hedging techniques adopted by MNCs in India based on survey on 50 companies (source: Goel 2012)

Figure 3 Derivative used for hedging FX risk in India (source: Sivakumar & Sarkar, 2008)

Although hedging options are concentrated at forward contracts, it is evident that MNCs in India are utilising hedging activities to manage its transaction exposure. As per Figure 3, the most popular foreign currencies include USD, Euro and Pound as the major trading partners of firms operating in India. Forwards are more preferred by MNCs operating in India over futures due to its OTC nature, as they have the requisite bargaining power to negotiate with their counterparties to match their exposures (Sivakumar & Sarkar, 2008).

Options are a more flexible alternative in the short-term hedging market. it is adopted by TCS to hedge its exposure to USD (Sivakumar & Sarkar, 2008). Because of its asymmetrical payoff regarding volatility, options grant TCS a profitable opportunity due to the high volatility of the exchange rate between USD and the Rupee. However, expensive upfront premiums may deter other MNCs from entering the option market. The implication entails that TCS may have a short planning horizons (Sivakumar & Sarkar, 2008).

Money market hedge may also be exploited as an alternative to forwards as it manifests in firms obtaining a loan agreement and a source of funds to fulfil their obligations under that contract (Goel, 2011). This approach depends more on the ‘differential interest rates’. (Goel, 2011, p 90) Recent fluctuations of the interest rates in the US, EU and India itself have added uncertainty to this approach, which makes forwards the most appropriate hedging technique. (Kim, 2011)

Swaps are also used by several car manufacture companies as long- term hedging strategies, it operates to rather hedge the firms’ operating exposure (Antoci, 2015).

OPERATING (ECONOMIC) EXPOSURE
Operating exposure is harder to measure and the mitigating mechanisms depend on the operational structure of each firm. The ultimate goal in mitigating this risk is to maintain a balance between its profit margins and market share in cases of adverse exchange rate movements (Goel, 2012).

PASS-THROUGH
The appreciation of Rupee is a downside risk for MNCs operating in India. It results in lower demand in both global and domestic markets for our products. If the firm is able to pass through the changes in the exchange rate onto customers, potentially demand can be sustained. However, our ability to pass-through the rise in value depends on the product’s elasticity of demand (Dumitrescu, 2009).

Financial Hedging

Table 1 Techniques used for hedging operating exposure by 95 MNCs in India (source: Goel 2012)

Figure 4 Pie chart for number of techniques used outlined in Table 1 (source: Goel 2012)

If firms can match up the currency of their cost and with the currency of their revenue, it can reduce their exposure to foreign rate changes. One method is to borrow foreign currency in Euromarkets (Prasad, 2016). Alternatively, it can be achieved by swaps, which is an agreement to exchange cash flows for an agreed period. The later method can be risky when RBI implements a tightening monetary policy, which increases the cost of borrowing domestically.

Operational hedging – FDI

Our firm will need to restructure its operations to manage its operating exposure. MNCs have the requisite resources to set up production lines in multiple foreign countries. Firms are therefore more flexible for production shifting as having their own offshore suppliers or subsidiaries. (Goel, 2012)

GCHL and Shima were Indian textile firms that mitigated its exposure to appreciation of Rupee by finding a cheaper source of cotton and shorting the output at a higher price in other countries (Bhaskaran & Priyan, 2015).

Suggestion:

Along with the QE in America, Trumps protectionism has hindered the growth of FDI in the US market. Therefore, its rival China can be an appropriate destination for FDI according to the OLI paradigm.

Owner-specific: Since our company operates on a multi-national level, it has competitive advantage such as economies of scale.

Location-specific: As China is the largest consumer of raw materials, it has developed a mature mechanism to hedge against their exposure in the market. Other factors including relatively cheap labour and a substantial domestic market confirms that China is a suitable destination for FDI. (Jethmalani, 2018)

Internationalisation: The potential issue lies with our firm obtaining control over the foreign investment. As China is an authoritarian republic, there may be heavy regulations imposed. However, as China loses a portion of its market share in the US, it is plausible for investment policies in China to turn in our favour.

In summary

Ultimately, MNCs including our company are victims to exchange rate fluctuations and therefore, it is crucial for firms to know how to hedge the foreign exchange exposure. Having analysed the current situation in India, the central banks are more likely to impose QT in the future than not, and economic repercussions will subsequently unravel. Monetary policy may be the root cause for some of the exposures that we face. Nevertheless, risks can be mitigated through implementation of risk management strategies.

References

Cite This Work

To export a reference to this article please select a referencing stye below:

Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.

Related Services

View all

DMCA / Removal Request

If you are the original writer of this essay and no longer wish to have the essay published on the UK Essays website then please: