Wednesday, November 30, 2011

Euro – will be or won’t be?

Whole world is pondering (and not for the first time) after almost 14 years of its coming into being. Euro came into existence in Jan of 1998 and took physical form in Jan of 2002.  To jog down the memory lane,  four monetary and budgetary convergence criteria for the member countries are (a) price stability (inflation criteria),  (b) stable exchange rate (with other member countries), (c) Government finance (threshold on gross debt and budget deficit as a % of GDP) and (d) interest rate (treasury rate as an indicator).

The sovereign debt crisis that is gripping GIIPS (Greece, Italy, Ireland, Portugal and Spain) is nothing but budget deficits created by excessive spending or insufficient tax revenue or both. France and Germany have had several budget deficit (as a % of GDP) breaches and got their violations waived; but Greece is a big one and financial markets are living with this nightmare!  This has put Euro’s debt crisis in bold on the dashboard of all and sundry and the world can’t take its eyes off the action (or lack of it)!

The union by all means encouraged free flow of capital to surging economies and it was meant to be.  However this caused imbalances in spending and fiscal deficits.  If only the peripheral economies had managed to get their act together and pushed up exports or attracted more capital inflows, the intensity of pain today would be far less.  Who wants to bet on dwindling economies with ballooning deficit and very low or no growth?  It’s a vicious circle!

The biggest challenge is lack of takers for sovereign bonds of some of its member countries. There are stories (hopes. Speculation and denials) floating around everyday dragging asset markets up and down (more down than up).  Can EFSF (European Financial Stability Facility) do the trick?

EFSF is a special purpose vehicle financed by member countries to help the countries facing debt crisis and to preserve financial stability in Europe.   EFSF promises substantial resources and is pushing IMF to play a significant role is fighting the situation. There is still no one number for the total firepower of the fund.  Hope it doesn’t turn out to be too little too late.

So will the union survive?  German and French officials are firefighting to calm the markets. But the pictures remains gloomy - growth, debt and unemployment and it is contagious.  It is a tall order to get the economies of Euro Zone integrated considering their very different internal dynamics.  Are we close to the end of another era?  Or could we expect a pleasant Christmas gift from European Summit scheduled for Dec 9?

What happens to Euro? The recent independent analysis by OECD, it stated the obvious and dismissed Euro’s chance of ever rivaling Dollar as a reserve currency (as once claimed by its founders).  Strange are the ways of the world.

While Euro’s existence is being questioned yet again, it still doesn’t seem to reflect the real state of the economy.  I am tempted to short the Euros some more! 

Wednesday, November 23, 2011

Slip and slide away...

There is a lot that’s going on in global financial market and even more at home.  Inflation woes, rupee finding new nadir every passing day (as we speak, there is a mighty hand at play helping our own battered currency), eroding investor sentiment and value (not necessarily in that order), ballooning current account deficit and the list could go on.  Currently though, the rate of depreciation of rupee seem to eclipse all other factors.

Indian currency has been Asia’s worst performer this year depreciating by a whooping 18% since August.  While the run on the rupee is triggered by Euro debt crisis, the stampede was more due to internal factor; lopsided positions with most imports and other dollar liabilities having been kept open when the markets were in a steady state and volatility abysmal. 

There is a variety of suggestion to control rupee’s slide.  Talk is cheap, right? One that particularly amuses me is to open a special window for importers. RBI seems to be telling the market ‘you made your own bed and now I’ll let you lie on it’.  They are doing a bit of damage control, but I don’t anticipate a great deal (and rightly so).  RBI may be micromanaging some areas to ensure overall health and compliance, but I believe market dynamics is merely it and should be left alone.

On the other hand, rupee seems to be achieving its equilibrium from a REER (real effective exchange rate) perspective.  Going by published statistics as of end October, rupee was overvalued by a little over 6.5%; it has depreciated close to 7.5% since.  Also NRIs are happily wiring $s back home to cash in on weaker rupee.  The trend would extend itself (I hope) for larger capital movements into the country.  These are some positives, though in long term.

Not for a minute it is being implied that the current level (or for that matter, any level) of rupee is the right level.  Panic and negative bias seem to be two strong elements of market force, at present.  Rupee seems to be slipping and sliding away feeling light as a helium balloon (but in  opposite direction).

So what to do we do?  We have a bunch of exposure unhedged / hedged and have no clue where the market is going! Good news is, you are not alone.  Better news is, it forces you to rethink your risk management strategy.  Market is ever changing (and challenging) and it’s important to consider insulating business from bizarre event/s such as this.

Time to go back to your drawing board!?

Wednesday, November 16, 2011

Structured approach to risk management

Globalization, tighter regulatory requirements and increasing shareholder involvement have re-defined the nature of risks faced by organizations.  As business environment is becoming more and more competitive and complex, boardroom discussions increasingly dwell upon internal control and risk management as effective tools to survive and excel. 

Market risk management is an important aspect of business and appropriate attention to this ensures that volatile financial markets don’t result in volatility in financial performance of an organization.  It is imperative to understand how market changes (changes in currency, commodity and interest rates) affect businesses, in order to plan and react quickly to events. It needs no further emphasis that market risk management is pivotal to running a business efficiently.  Let’s take a quick look at important ingredients of sound risk management:

Firstly define Objective. Sounds obvious, right?  In reality, it is often unclear whether an organization is looking to out do market or protect its budgeted rates or avoid accounting losses or run its treasury as a profit centre or a mix of some / all of the above.  Setting objective / benchmark to measure performance is first step to managing risk proactively.

Approach to managing risk should be arrived at, after careful consideration of various aspects viz (1) organization’s risk tolerance (2) how to gauge exposure and risk (3) historical simulations (4) stress / scenario testing (5) why should the exposure be hedged (6) when and what should be hedged (7) cost of hedging (8) internal resource availability (people, skill, systems& bank limits), (9) management commitment etc. 

Strategy: (a) management style (Is it going to be one of dynamic? all or none (100% or 0%) hedge? net or gross exposure management? based on cost of trade finance?) (b) define internal authority on hedge decisions (c) products (forwards, options, swaps) / tenor and approval matrix (d)  MIS and escalation process (e) front office / back office segregation (f) whether external expertise to be sought for day-to-day decision making? and so on.

Monitoring and Control: Monitoring indicates performance measurement. It helps identify gap in resources, training / system needs etc. More importantly, monitoring and control ensure compliance and enable periodical fine tuning of strategy and adapt to changing business environment.  Corporate risk management is a process, after all.

Risk Management Framework / Policy documents all of the above and disciplines risk management practice. A board approved policy is the best form of communication to all stakeholders on how risk is being approached and mitigated.  Increasingly regulators and financial institutions derive huge comfort from a corporate customer with a structured approach to risk management.

POIESIS risk solutions would partner with your organization to help you effectively manage market risk.  Our service is customized to suit your current preparedness, individual needs and would be tailored to tackle key risk management challenges.