FOREX RISK: STUCK AT PLAIN VANILLA

SRI LANKA'S FOREIGN EXCHANGE MARKET HAS BEEN A PLAIN VANILLA ONE SINCE THE 1980S, BUT MANY BUSINESSES STILL DON'T VALUE ITS BASIC PRODUCT, THE FORWARD-CONTRACT

In 2019, Perry Savundranayagam became the Asia President of the Paris-based global financial markets professionals’ body ACI Financial Markets Association (ACI). He is the first Sri Lankan appointed to that position and also ACI’s Management Board. Founded in 1955 in Paris, ACI counts over 9,000 professional members across 63 countries. Membership requirements include observing the principles of behaviour and market practice contained in the FX Global Code and other market-applicable codes of conduct.

Savundranayagam, who heads the Global Markets Corporate Sales division at HSBC Sri Lanka, wants to use his position within ACI to build awareness and capacity in foreign exchange risk management here in Sri Lanka and the region. However, his task is a challenging one.

“Currency risk is omnipresent and occupies considerable mind space of business managers, but only a few of them manage risk,” Savundranayagam says. One reason for this is Sri Lanka’s shallow foreign exchange market does not have the depth in financial instruments and products to mitigate complex currency risk. In a chicken-or-egg situation, there is no demand for these products either.

Excerpts of the interview are as follows:

Businesses have experienced considerable currency risk over the last two years, so what’s the outlook for the rupee in 2020? 

Savundranayagam: The rupee will likely weaken at the outset against the greenback to around Rs190 against the U.S. dollar in 2020 considering domestic and external uncertainties. If FDI, tourism and capital market inflows improve, the currency could be stable. The currency was relatively stable ending 2019 a little over Rs180 to a dollar, after sharply depreciating the previous year.  The first six months of 2020 will be a critical period with uncertainties carried forward from the previous year and new threats emerging. Last year, the China-U.S. trade war and Brexit resulted in much of the uncertainty, but global dynamics can shift in a blink of an eye. Right now, it’s the coronavirus originating from China that’s upsetting markets.

Uncertainty and risk will always remain; only the events change. In Asia, economic growth will be slow. Most central banks will likely ease interest rates to stimulate economic activity. However, these measures will only contain sliding growth rates. China will grow at around 5% in 2020 and India at 5-6%, both below potential, which dampens the outlook for the region. Supply chains are continually shifting, and currency fluctuations in one country can have a knock-on effect on markets everywhere. But it’s not all risk.

Global supply chains are shifting to Malaysia, Indonesia, Vietnam and the Philippines due to global economic dynamics and this could benefit economies like Sri Lanka if we can identify those emerging opportunities and create a conducive policy environment to exploit them. Attracting FDI will be critical and will require a considerable policy shift. Emerging markets Sri Lanka included still enjoy yield differentials which should attract global funds provided the domestic environment is investor-friendly.

A lot depends on achieving policy stability to mitigate the impact of some of the unfavourable calls from the rating agencies. I think we do have a good story to tell in Sri Lanka, but we need to convince global markets and give investors’ confidence to bring money to this country.
How can businesses mitigate currency risks when they have little control over global or domestic events that impact the rupee?

Savundranayagam: Sri Lanka does not have sophisticated instruments or complex derivatives to manage currency risks, and only a few firms make use of even the uncomplicated tools available to them such as forward contracts. There’s plenty of opportunities to manage risks even with such plain vanilla instruments, but few make use of them. Apart from the large companies, not enough small to mid-sized businesses actively manage currency risk. For many, managing foreign exchange rate risk means calling a bank for a more competitive rate.

Depending on the market forces of the day, and the relationship with their banker, a business may get a few extra cents by engaging in active negotiations; but that’s it. The company is still open to currency risk from currency fluctuation. For instance, when the rupee fell sharply against the U.S. dollar several years ago, USD sellers that entered into forward-contracts had markto-market losses.

And in the same way, USD buyers who had not hedged had actual foreign exchange losses. In 2019 it was somewhat the reverse. There is no right formula. You need to be dynamic in making informed, data-driven decisions. This is not unique to Sri Lanka. Companies need to invest in people and systems. As Sri Lanka deepens integration with the outside world, foreign exchange risk management will be critical for any business irrespective of size or connectivity to the global economy. The proposed International Financial Centre at the Colombo Port City will transform the financial landscape.

There will be new business opportunities with the outside world. As the economy matures, even a small business must understand how market instruments work. Importantly, they will have to understand and track risks.
What are the instruments available to mitigate currency risk?

Savundranayagam: Sri Lanka has been a vanilla market since the 1980s, but it needs to mature and introduce a few complex derivative products that can mitigate complex risks. However, even the forward exchange market, with contracts that go up to two years, lacks breadth and depth. Transaction ticket sizes rarely reach over $2 million and total trades average between $25-45 million daily, which is nothing much.

If Sri Lanka is serious about attracting FDI and investments to its capital markets, then the forex market will need a capacity and liquidity boost. In that context, the recent easing of exchange controls was a step in the right direction because it made it easier to transact in the forex market. The Central Bank has issued guidelines on how to structure derivatives, but the market appears uninterested.

We don’t see enough corporates telling us they need better derivative products apart from the plain vanilla forwards. One reason for this may be the small size of the foreign exchange market; out of 26 banks, only a very few actively trade daily. As I said earlier, liquidity is a problem. For instance, if an investor brings in a sizeable value, no single bank can warehouse that amount of risk by itself. While the regulatory guidance is clear, the market is taking its time to mature, not enough banks and corporates are trading actively but this could change quickly if the economy realises its true potential over the next three to five years, which will potentially transform this country.

This will also mean exposure to more complex risks. As an industry, banks, and as professional traders and risk managers, we have a responsibility towards our clients. Suitability, ethical conduct, understanding the risk profiles of our clients and making sure clients are fully aware of all the risks has to be at the forefront of any product offering. Risk is a part of life, and you cannot escape it. The key is to be able to understand risk and build capacity to absorb and manage it. Managing currency risk is a holistic discipline beyond a transaction focus. ACI provides professional education to members and none members to upskill their knowledge on both the technical and ethical front. We have online technical courses that are practical, covering every aspect from the frontline dealing room to the back office operations, aimed at specialists in the foreign exchange, fixed income, currency and commodity markets.

Separately, ACI has developed methods to attest adherence to the FX Global Code. This is essential for banks and now also for other businesses. The code serves as a stamp of assurance that market participants are like-minded and working within a globally acceptable governance framework. This is very relevant and important in today’s world.