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Exotic currency derivatives turn into losses for MSMEs
Oct '08
If sub-prime crisis has devastated the financial sector in US, the fallout of currency derivatives would result in death knell of MSME segment unless this august body take immediate steps to help the exporters in this hour of crisis.

You may recall that since 2006 the US dollar has been depreciating against most global currencies. In April 2007 the rupee, keeping in line with its global peers, too began to appreciate significantly against the dollar. And as the rupee appreciated, exporters began to lose both their top-line and bottom-line.

In this situation, banks (mostly private and foreign, but also some nationalised ones) took advantage of the situation to sell exotic derivative products. Innocent exporters, mostly MSMEs, whose dealings with banks hitherto were based only on trust, believed the words of the banks and signed several derivative contracts without realizing the potential risk and unaware of the fact that those contracts are only speculative in nature.

It is important to highlight that these products were sold in utter disregard to Indian Contract Act. Contracts without genuine underlying exposure are a speculative wager, which under the Indian contract law, is void.

What is appalling to note that one of the fundamental requirements to contract under the Indian contract law is that the parties to the contract must be 'competent.' If even learned Chartered Accountants are incompetent to understand these instruments, how does one expect exporters to understand them, especially when the persons explaining the risks too were no experts.

These currency derivatives were also in violation of RBI guidelines.In order that SMEs understand the risk of these products, only those bank with whom exporters have a credit relationship are allowed to offer such facility.

Moreover these facilities should have some relationship with the turnover of the entity Both these conditions were violated as the banks who have offered the products were not the bankers of the firms and the value of the contract has no relationship with the turnover of the concern.

Secondly, Derivative transactions that do not hedge any underlying exposure are not permissible and are contrary to RBI guideline. Banks are required to verify the genuineness of the Underlying Exposure. However no such verification was carried out.

Thirdly, RBI allows hedging only for protecting against currency risk. However the derivatives offered multiplied their forex risk. In one of the contract, exporter effected purchase of US$ 62.5 million and net sale of other currencies EURO 7.75 million, GBP 27.75 million, Yen 167.12 million and Rupee 63.95 million.

While bank had forward sold to him US $ 62.5 million, he actually needed to sell –not buy- US $ as 90% of his exports were billed in US $.Here purchase of US $ 62.5 million increased, not hedged his risk.

There is serious issues of breach of trust by banks. The banks enticed the exporters to enter into these contracts. When exporters express their inability to understand these complex financial products, these banks took upon the role of financial advisor and assured the exporters that they have experience in handling these products. These bankers even suggested to try our sample deals.

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