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Forex derivative losses haunt Ludhiana firms

April 11, 2008 09:33 IST
In this boomtown of north India famous for its hosiery and cycles, the rich and famous discuss in hushed tones the losses on derivative trades that many companies in town are sitting on.

A senior executive with a Ludhiana-based company said almost every large company or exporter has dabbled in them. These products were sold by banks much the same way as agents sell life insurance policies.

Experts (forex consultants and CFOs) estimate the notional losses on derivative products in Ludhiana to be Rs 200 crore to Rs 300 crore (Rs 3 billion), with a prominent textile player leading the table. But no company is willing to talk about their exposure or losses.

A few companies, such as Vardhman Textiles, part of the S P Oswal Group, said they had no exposure.

''We have not done a single deal in a decade or so. I have done options to cover my imports. But to convert rupee loans, we have not done any deals,'' said Neeraj Jain, CFO of Vardhman Textiles. He says the company had signed some deals in 1995-96, on which it lost Rs 6-7 crore (Rs 60-70 million), and paid the day the contract matured.

But Vardhman seems to be in a minority.

Companies are obviously circumspect about giving out figures on how much mark-to-market losses they are carrying. But losses are pretty high, spread across 20 to 25 big and small companies, said a forex expert, who tracks the companies in Ludhiana.

Two textile companies have gone for litigation. Nahar Industrial Enterprises, part of the Rs 1941-crore (Rs 19.41 billion) Jawaharlal Oswal Group (Nahar) has moved court against Axis Bank while Garg Acrylics Ltd, part of the Rs 600-crore (Rs 6-billion) Garg Group with interests in steel and textiles, has moved court against ICICI Bank.

Both these companies allege mis-selling by banks. ''To cut interest costs, the banks initially suggested certain cost-reduction structures, like currency swaps, on which we will get some interest cost benefit but won't have any downside risk,'' said Sanjiv Garg, MD, Garg Furnace and a director of Garg Acrylics.

They started with currency swaps, but then went for one-touch options, two-touch options, and offered premiums of $40,000-50,000 per deal.

In guise of this, what they have done is exposed the companies, as an option writer, to unlimited risks, which is not permitted. "We never thought we are going for speculative deals, but thought these were cost-reduction exercises,'' added Garg.

Garg has company. Almost every other CFO said there are lots of small companies involved that one may not have ever heard of.

Kamal Oswal, MD, Nahar Industrial Enterprises, said "The banks suggested it as a cost-reduction exercise. But it may end up as a capital-reduction exercise."

Most companies are cagey about disclosing their exposure or losses, and understandably so. But losses, in some of the cases, are so heavy that they could wipe out the entire capital of a company.

Another reason why firms are reluctant to discuss specifics of the cases is that they don't want to reveal all their cards (arguments) in their legal battle. ''We cannot expose all our arguments; they are the grounds on which our plaint is based,'' said the CFO of a company which has filed a case.

The Reserve Bank of India has mandated that banks doing derivative deals with companies need to ensure that there's an underlying, the company has a risk-management system and the risk appetite, and also the products are appropriate for the company. What they are trying to say in their complaint is that the contracts were speculative, other than
envisaged in the RBI guidelines, an expert said.

Sources said ICICI Bank and State Bank of India, who were aggressive in selling these products, could be in trouble with their deals in Ludhiana.

''Their senior forex managers were camping in town, begging companies to cover their losses through fixed deposits,'' said a corporate observer in Ludhiana. Punjab National Bank and Axis Bank are two others which have exposure here.

Banks are saying that if you are sitting on a mark-to-market loss of Rs 6 crore (Rs 60 million), at least open a fixed deposit for Rs 60-70 lakhs (Rs 6 to 7 million) or 10 per cent of the loss.

Strangely, the banks never asked for any cover (guarantees) while signing the contracts.

It's not that everyone is going for litigation. ''It's the same set of banks that have to lend you money. Lots of people are paying up,'' said a CFO with a leading corporate in Ludhiana on condition of anonymity.

Companies, who have taken a hit beyond their capacity, are going for litigation and are harping on RBI guidelines. ''They have put responsibility on the authorised banks to check whether
these products are suitable and appropriate, and the company has adequate risk appetite for such products,'' said a CEO.

CEOs said banks have converted a rupee loan into a dollar loan, and then into Swiss Franc. In Swiss Franc, they have embedded the option. Companies also allege that in some cases, banks have used a rupee loan as an underlying and done cross-currency transaction without converting the rupee liability into a foreign exchange liability, which is also not

These companies are pointing to reports that suggest that banks are expected to make super-profits for FY 08 on back of gains made by selling exotic products to companies. This is reflected in the advance taxes paid by banks for FY 08.

Taxes paid by five banks, which have the highest exposures to derivatives, increased 10 to 90 per cent. Advance taxes are paid on a bank's internal estimates of profits.

On Wednesday, Yes Bank reported a 112 per cent increase in net profits to Rs 200.02 crore (Rs 2 billion) for the year ended March 2008. It won't be surprising if other private banks report similar increase in profits.

''While six banks may report super profits, 2,000 companies across the country are suffering losses,'' complained a CEO.

CEOs said banks seemed to have clearly flouted norms. ''Forget about underlying, many deals have been done under names, where companies don't exist physically,'' said a senior executive in Ludhiana. For instance, if a company is called XYZ Ltd; it has executed derivative deals in the name of XYZ Export Pvt Ltd.

Corporate observers say bigger companies, which have much at stake (reputation and banking relationships across group companies), will honour the contracts while smaller firms may just start doing business in some other name.

A senior consultant with a leading tax firm said if banks have entered into these deals without an underlying or taken exposures beyond the size of a company's balance-sheet, they will be in trouble as these companies will turn defaulter.

If a company fails to provide for the losses on the due date when the contract matures, banks will take a hit as they will have to provide for the losses. Banks could also get into regulatory issues if they have taken an exposure beyond the size of a company, said the CFO of a leading infrastructure company.

Greed vs risks

If financial institutions in the US suffered as they took higher risks by lending to sub-prime borrowers, companies in India will be hurt because they have taken far higher risks than they can handle.

It all began four-five years ago, when companies began taking small exposures of Rs 1-2 crore in currency swaps, options. As they began making money, they started increasing their exposures.

''We made profits and entered into more contracts. Only when the currencies went haywire and banks started making margin calls around November that we realised we had taken unlimited risks,'' said a CEO.

What's interesting is that it's not just exporters or companies with foreign currency exposures that went for derivative deals. Companies have swapped their rupee loans to Swiss Franc to get an interest benefit of 2-2.5 per cent, due to the carry that was available, and the risk they were willing to take.

''It seemed like a reasonable risk to take if the franc hasn't breached 1.10 level against the US dollar for 20-25 years,'' said a forex consultant.

''Companies were not required to make any upfront payment and there was no risk, so companies went for it. The market reacted to sub-prime crisis, the currencies went haywire and all the bets went wrong,'' explained the forex consultant.

A majority of the deals were in Swiss Franc and were executed at a rate of 1.25 franc for every dollar. Banks and companies thought they were protected against the movement of the franc against the dollar as the lifetime lowest rate was 1.10; people thought it's highly unlikely that the franc would breach these levels.

The options with knock-ins meant that if the franc breaches a level below this, say 109 to the dollar, then the company has to pay the difference.

''The deals were executed when the franc was trading at 1.25 to the dollar while today it is trading at 1. They sold at 1.25 and now have to buy at the rate of 1, at a 25 per cent loss,'' explained the CFO of a leading corporation in Ludhiana.

''Nobody thought of this kind of forex movement. Earlier, an option would get knocked out within a week (if a company had entered into a contract at 1.25, in one week the option got knocked out at, say 1.30). The company would do another deal at 1.20, make money, and do another deal at 1.15,'' said the CFO.
Ranju Sarkar in New Delhi