05 June 2006

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Since compliance with Clause 49 of SEBI's listing agreement became mandatory as of April 1, 2005, all listed companies have, in their March 2006 accounts, certified that the CEO and CFO "have evaluated the effectiveness of the internal control systems of the company and they have disclosed to the auditors and the Audit Committee deficiencies in the design or operation of internal controls, if any, of which they are aware and the steps they have taken or propose to take to rectify these deficiencies." However, the veracity of this certification will only start coming out in the wash from this year onwards, since there is often a huge gap between regulatory compliance and actual effectiveness of controls.

To give just one instance, a large manufacturing company I know had mandated one of the Remaining Four global audit/consulting firms to create an effective set of processes and controls to ensure that the CEO/CFO certifications could be made. This company has pretty high corporate governance standards and - unlike most other companies - it began this process as far back as April 2005, even though the certification would have to be made after March 2006. I understand it was a comprehensive project and, for market risk management, the company adopted the recommended policy and had a treasury software solution integrated in with its ERP.

We advise the company on risk management and, to our surprise, we found some glaring and potentially hugely costly lacunae. For instance, the company's policy on derivatives use had a dollar-denominated limit on the maximum permitted size of the company's outstanding derivative portfolio. This is standard boilerplate in so-called "global best practices" risk management policies, and companies need to watch out for such standardized practices which may come with a board-accepted brand name but which do not provide any real value. This approach - of seeing a dollar-denominated limit on, say, derivatives - is totally inadequate since it does not give the company any idea whatsoever of its risk, of how much money it could lose. In actual fact, the risk, in rupee cash flow terms on a derivative portfolio of, say, USD 20 million would depend on a large number of factors, such as the type of transaction (in general, the more complex, the riskier), the other currencies involved (the more volatile the currencies, the greater the risk), and, of course, the actual volatility in the market. Simply having an exposure limit of USD 20 million does not measure risk at all. For this reason, it is critical that a company set its risk limit in rupees (assuming its balance sheet is in rupees) rather than set exposure limits in dollars. Of course, this requires strong internal (or outsourced) analytic capabilities, particularly when, as in the present and many other cases, the kinds of transactions companies are undertaking are increasingly complex.
Again, companies need to have a clear articulation of the kinds of derivatives transactions they undertake, with a loudly defined negative list. In the example I mentioned, I was again surprised that the policy did not have any such constraints.

In the event, we found that the company had entered into several complex derivative transactions (where it would make money if yen LIBOR did not rise beyond a certain level), which, within two months, were seriously out-of-the money on a mark-to-market basis. Now, the company hadn't lost any money (in terms of cash flow) yet, but with markets suddenly getting volatile, the treasury was getting jittery and wanted to exit from the transaction. In one such case, the bank was willing to reverse the transaction at a loss to the company of Rs. 1.5 cr, which was more than 1% of the company's bottom line. The treasury did not want to accept the loss (if it did reverse the transaction), but it was concerned that the market could move further against it. And - surprise, surprise - it was contemplating another derivative transaction that would give it a front-end cash flow (sufficient to cover the loss on the earlier transaction) but which would create a fresh risk, this time on USD/JPY.

Now, this is just one example. But, from my experience, I know that it is not a one-off. Several companies, who were tempted into the front-end savings offered by some exotic derivative transactions over the past two years, have actually jumped deeper into the water by hiding losses by rolling over the risk. However, this is the first time I have seen it happening within the bounds of a CEO/CFO Clause 49 certification of risk management policy.

The point of this story is not to whip the company, who, of course, shall remain nameless, but rather to highlight the need for managements to recognize that mere regulatory compliance is seldom sufficient to provide a company with truly effective controls. This is because (a) regulators are generally not exposed to the market from a user perspective, and (b) more importantly, regulations are necessarily framed in general terms, whereas companies have to operate in specific micro-environments. And, finally, while certification from outside consultants is all very well, there is ultimately no substitute for doing it yourself.

And if you can't - if, say, the structure is too complex to value daily - don't.

Currency Market View - Rupee and Majors

USD/INR

Fortnightly movement: O-45.6200 H-46.5500 L-44.4800 C-45.89.
Sentiment: Highly volatile ranges
Expected range for 1 Month: 45.25- 46.25
Expected range for 3 Months: 45.00- 46.50

The rupee was under huge pressure for most of the fortnight, falling to a low of 46.55, a drop of over 2% from the start of the period. This was driven primarily by the collapsing equity market, which created a significant off shore arbitrage. We did see some exporter selling at around 45.39, which was the previous recent top; banks, too, joined the party at 46.50, and with the softening of the dollar overseas, this broke the rupee bearishness and it closed the fortnight at 45.89, not much weaker than where it started.

The sharp gain (of around 65 paise) in the last two days of the fortnight, also reflected central bank selling of dollars and the reserves fell after a long time, ending at $162.9 as against previous reading of $163.35. The 6-month benchmark forward premium, which stood around 0.9% last fortnight, closed at 0.65% this weekend.

With global markets likely to remain highly volatile, we would expect similar (if attenuated) conditions domestically. Likely as not, both sides of the user spectrum will get opportunities to hedge at attractive rates over the next one month, but short term exposures should be hedged out at earliest. Medium term is, again, hugely uncertain. While the majority of opinion calls for a weaker dollar, our view - see articles - is that the dollar is likely to strengthen on the crosses. Of course, this strength may not feed into the domestic market, since RBI will likely be more concerned about inflation than export competitiveness. Short (dollar) positions are in greater danger - unfortunately, option premia are quite high, so we would not recommend either vanilla or exotics at this time.

EUR

Fortnightly movement: O-1.2759 H- 1.2938 L-1.2695 C-1.2906
Sentiment - slightly positive
Expected range for 1 Month: 1.2500 -1.3000
Expected range for 3 Months: 1.2300 - 1.3000

The Euro found a floor just under 1.27 and bounced back smartly on May 22 to the high 1.28s following hawkish comments from the ECB Chief Economist, Otmar Issing. Expectations of an ECB rate hike in June month helped to prevent sharp declines. On the other hand, Fed Chairman Bernanke's hawkish testimony, upbeat US new home sales numbers and hence, rising expectations of a Fed rate hike on June 29 capped the Euro around 1.29. Last Thursday's US data was worse than expected. In particular, the US ISM manufacturing index not only fell more than expected to hit a 9-month low of 54.4 but also slid well below its rising Eurozone counterpart which tocuhed 57.0, the highest level since August 2000. Friday's US payrolls data was equally disappointing. Expectations of a Fed rate hike on June 29 have naturally waned quite a bit and the Euro climbed and closed over 1.29 with apparent ease.

Unless the dollar gets some early respite, a strong test of 1.30 may not be far away. Still, only a decisive rally over 1.30 is likely to abort our medium term Euro bearish view of a decline to 1.10 in 12 months.

What about Henry Paulsen, the new US Treasury Secretary nominee? He may not have as long a tenure as Robert Rubin during the Clinton Presidency or Donald Regan during the Reagan Presidency but if history is any indication, the dollar will probably strengthen over the medium to long term.

GBP

Fortnightly movement: O-1.8762 H- 1.8884 L-1.8530 C-1.8804
Sentiment: neutral
Expected range for 1 Month: 1.8300 -1.9000
Expected range for 3 Months: 1.8000 - 1.9000

Sterling finished last fortnight marginally up against the dollar but lower against the euro with the UK manufacturing PMI declining more than expected to 53.2 in contrast to the Eurozone PMI that rose unexpectedly to 57 as against an expected decline.
Sterling is still quite a bit below last month's high of over 1.90 and its slide may resume unless US data continues to disappoint during this fortnight as well.
Only a decisive rally over 1.90 may abort our view of a decline to 1.65 in the next 12 months.

JPY

Fortnightly movement: O-111.88 H- 113.36 L-110.96 C-111.78
Sentiment: neutral
Expected range for 1 Month: 110.00 - 115.50
Expected range for 3 Months: 106.50 - 115.50

Dollar/yen traded last fortnight mostly between 111 and 113 before ending last Friday marginally down around 111.80.

At the start of last fortnight, Bank of Japan Governor was reported to have commented that the central bank must exercise caution and will adjust i.e. hike interest rates slowly since not all areas of the economy have fully emerged from the slump. Japanese core CPI rose 0.5% y/y in April, rising for the 6th consecutive month but Japanese government officials considered this to be just a sign of improvement and not an end of deflation. Consequently, the market now seems to expect the BoJ to end its zero-rate policy as late as October instead of June or July. These developments together with upbeat US new home sales data, Fed Chairman Bernanke's hawkish testimony as also the hawkish minutes of the May 10 FOMC meeting enabled the dollar to rise as high as about 113.35 before slumping end of last week on a barrage of disappointing US data especially the non-farm payrolls.
The dollar is likely to find support around 110.50 yen before a renewed and probably successful attempt to climb past 113.50 enroute to 115.50. Only persistently weak growth data and benign inflation data from the US may push the dollar towards 109 and perhaps lower.

Dr Risk's Prescription

Was the dollar's short-lived strength just a bear market rally?

You may well be tempted or prompted to think so in the wake of the disappointing US data last Thursday and Friday.

However, one other development occurred last week that may have long term implications for the US economy and the dollar. And, that is President Bush's nomination of Henry Paulsen, a veteran Wall Streeter from Goldman Sachs to take over from John Snow as US Treasury Secretary. This has been perceived as a defensive measure in some quarters for the purpose of shoring up confidence in the dollar without loss of trade competitiveness. Doubts have been expressed whether Paulsen will adopt a 'strong dollar' mantra as Rubin did. Compared to the July 2001 high of 121, the dollar index is now around 84 and not too far from the December 2004 low around 80.40. If the US trade deficit is well over $60 bn a month even with an 'undervalued' dollar, renewed general dollar depreciation against the major currencies is unlikely to reduce the trade deficit much. However, it may certainly lead to loss of confidence in the dollar and aggravate the problem of funding the US current account deficit apart from leading to imported inflation. This will then require even higher interest rates to attract foreign capital.

In our view, Paulsen has no other choice than to adopt a strong dollar policy wholeheartedly and communicate his conviction firmly and clearly to the market and the media just as Rubin did, that a strong dollar helps to keep inflation and interest rates low. In short, he may well have to emulate Rubin. And, Paulsen a veteran Wall Streeter from Goldman Sachs may be perfectly suited to emulate Rubin who was also a veteran Wall Streeter from Goldman Sachs. And, in some ways the circumstances at the beginning of 1995 are similar to those prevailing now. After cutting the Fed funds rate from 9.75 in early 1989 to 3% in September 1992 and keeping it unchanged till February 1994, the Fed hiked it to 6% within a year! When Rubin took over from Lloyd Bentsen, the dollar was already in the dumps and within a few months, dollar/mark fell to the all-time low of 1.3430 while dollar/yen fell to the post WW-II low of 79.70. Now, when Paulsen takes over, the dollar index at 84 is not far from the dumps i.e. the December 2004 low of 80.40. Against the Euro too, it is not far from the [dollar] dumps of 1.3665 seen in December 2004.

On the interest rate front, history has been nearly repeated with the Fed having cut the Fed funds rate from 6.5% to 1% from January 2001 to June 2003, keeping the rate unchanged till June 2004 and then hiking it to 5% within the next 2 years. In 1994, the Fed was perceived to be behind the curve and the dollar fell sharply even as the Fed continued to hike rates. Last year was different. The Fed enjoyed the market's confidence and the dollar strengthened but in the last 5 months the dollar has surrendered most of the gains. The big question is whether history will now repeat on the dollar front. It may if the Fed is perceived to be getting wishy washy in controlling inflation i.e. 'behind the curve'. The dollar may also get dumped if the US Administration 'foolishly' calls for strengthening of Asian currencies because as we have seen while the US doesn't get what it really wants which is a much stronger yuan, the dollar may weaken excessively against the yen and other majors leading to a dollar crisis.

So then what is the way out? Well, this may seem weird but if the US can have an indicator like core inflation by excluding the 'offending' components like food and energy, wouldn't it make sense to have a similar indicator for the trade deficit? How about measuring, reporting and monitoring the core US trade deficit excluding the 'offending' component namely the deficit with China?!

During Robert Rubin's tenure, dollar/mark rose from 1.3430 to about 1.95 and then to 2.3780 after Lawrence Summers took over. With the dollar index around 84 and the dollar undervalued by about 16% against the 6-currency basket, is it too much to expect dollar appreciation of say 15% in the next 12 months or so with a meaningful and well-articulated strong dollar policy?