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    Posted on 19 March 2012
    Bibhuti Pati

    Forex derivatives a bigger scam than 2G

    Nineteen banks, which violated the RBI and FEMA guidelines to sell forex derivatives to exporters in 2008, caused a monstrous loss of Rs 25 lakh crore

    Bibhuti Pati

    IT’S A scam with an estimated value of approximately Rs 25 lakh crore, much bigger than the 2G scam that rocked the country in 2010. Nineteen banks, which violated the Reserve Bank of India (RBI) and Foreign Exchange Management Act (FEMA) guidelines to advise and sell forex derivatives to Indian exporters in 2008, resulting in humongous losses to them, have been penalised by the RBI negligible amounts ranging from Rs 5 lakh to Rs 15 lakh each. Several other countries have also faced major economic crises in recent times, as a result of volatility due to similar derivative contracts. Even Barack Obama has noted that unregulated derivative contracts are the main cause of recent financial crises. In the Indian context, the RBI has stated that the losses sustained by customers do not amount to gain by the banks as a result of such derivatives. The question then is — who stands to gain from derivatives during volatility in the money market?

    Amidst the dying embers of the 2G scam, and the sparks flying from the anti-corruption movement led by Anna Hazare, however, there is one scam that has somehow got buried.

    The RBI recently investigated violations of FEMA by 19 banks. The immediate victims of these violations were importers, exporters and firms selling foreign exchange derivative contracts, resulting in massive losses due mainly to fluctuations in the value of the dollar. What has recently come to light is that the RBI itself had not vetted any of the contracts that were sold, a fact it has admitted. A few of the erring banks have been penalised relatively negligible amounts of Rs 5-15 lakh. “The scam is estimated to be valued at approximately Rs 25 lakh crore, much bigger than the 2G scam,” says Orissa High Court advocate Manoj Mishra.

    As per the CBI affidavit in the Orissa High Court, “The RBI has been monitoring the gross mark-to-market (end-to-end) losses incurred by the banks. As on December 2008, the gross mark-to-market gains (that correspond to losses incurred by consumers) of 22 banks that were in the business of derivatives work out to Rs 31.719 crore,” says RP Luthra, advocate, Delhi High Court.

    This figure, however, is contested by Pravajan Patra, an eminent economist, in a PIL filed in the Orissa High Court. His contention is that the total value of derivative contracts sold in India and approved by the RBI is $3 trillion, based on the statement of the then finance minister P Chidambaram in the Rajya Sabha. Compare this to the total GDP of India, which is not more than $1 trillion, or its total export and import (including oil bills), that do not exceed $500 billion a year on average. The fluctuation in the value of the dollar during the period in question in 2008, however, was Rs 8.50-10. If this difference is multiplied by even the (conservative) estimate proposed by Chidambaram, that of $3 trillion, we end up with a loss in excess of Rs 25 lakh crore. Compare this to the estimated loss incurred by the exchequer in the 2G scam — Rs 1.76 lakh crore. Peanuts.

    Based on the PIL, the Orissa High Court ordered a CBI investigation into these missing funds. The court directed the CBI to hold a preliminary inquiry. Instead, the CBI just sent a questionnaire to the RBI and investigated the president of a forex derivative consumer forum, mere eyewash as opposed to the inquiry that was required.

    In addition to this, the 19 banks which violated RBI and FEMA guidelines have paid a negligible penalty. The RBI penalised the banks in its order of April 19, 2011 for violations of its guidelines under the Banking Regulations Act, 1949, and found the banks guilty on various counts, ranging from failure to carry out due diligence with regards to suitability of products, to selling derivative products to users without risk management policies, for not verifying the adequacy of underlying and eligible limits under the past-performance clause. Then in August 2011, the RBI, in response to an rti filed by Delhi lawyer Karan Jain, admitted that the banks had flouted FEMA and RBI guidelines.

    But how did 19 major banks manage to violate FEMA rules simultaneously and with impunity, without being in conjunction with a larger purpose? With the very economy of the country at stake, could this monetary crisis possibly have been generated to siphon off significant amounts of money abroad? Where this money has gone can only be a matter of speculation, and leaves one to believe that there is, indeed, a larger conspiracy.

    Apart from this, a surprising admission by the RBI was that it does not vet all forex derivative products sold by banks in the country, in effect leaving the door open for a repeat of such scandals in the future. A CBI probe is definitely needed to look into how these violations took place, and how exporters, who are the main victims of the scam, can get some reprieve.

    What are unregulated derivative contracts?

    WHAT, THEN, is a derivative? It is a contract between two parties that specifies conditions under which payments, or payoffs, are to be made between two parties. It is often used to hedge a transaction.


    . It is a contract between two parties that specifies conditions under which payments, or payoffs, are to be made between them

    . At any particular point in time, if the conversion rate is Rs 40 to a dollar, an exporter should get Rs 40 lakh for exporting goods worth $1 lakh

    . If, by the time the transaction takes place, the value of INR appreciates to Rs 35 per dollar, the exporter, even though his goods were worth $1 lakh, would eventually end up with Rs 35 lakh as payment

    . Hence, to avoid such loss, exporters are encouraged by banks to enter into a derivative contract

    To understand how this works, let us look at an example: We know that when an exporter sells his goods abroad, he transacts through banks authorised to deal in foreign exchange. Let us suppose that for a particular exporter in a particular transaction, the export is worth $1 lakh in the US. The exporter expects to get back an amount in Indian rupee (INR) corresponding to the conversion rate prevailing at that time.

    Let us now suppose that at any particular point in time, the conversion rate is Rs 40 to a dollar. The said exporter should get Rs 40 lakh for exporting goods worth $1 lakh. If, by the time the transaction takes place, the value of rupee appreciates to Rs 35 per dollar, the exporter, even though his goods were worth $1 lakh, would eventually end up with Rs 35 lakh as payment, effectively losing Rs 5 lakh during the transaction due to volatility in the exchange rate. To avoid such loss, exporters are encouraged by banks to enter into a contract whereby the exchange rate is insured or sealed at a particular level, so that even if there is an unexpected fall in the rate, the exporter would not suffer big losses. Therefore, when the market is volatile and the rupee appreciates alarmingly against the dollar (that is, the net return in rupee against the dollar falls), the exporter sustains no loss if his product value is secured/insured by the derivative contract. On the other hand, if rupee depreciates (that is, the net return in rupee against the dollar rises), the exporter sustains a loss, as due to the same contract, he would get less amount than the actual conversion value. Thus the derivative, in this case, protects against rupee appreciation, but not against depreciation.

    The Derivative Regulations of 2000 issued by RBI and FEMA regulations detail procedures for regulating such derivative transactions. As it turns out, they were clearly flouted in 2008.

    It can now be understood as to why exporters and corporate houses, apprehensive of future appreciation of the rupee that would lead to huge losses, and being misinformed and misdirected by the banks, would enter into long-term derivative contracts.

    This is exactly what happened. In 2008, the price of steel skyrocketed, and as a result, the construction industry was heavily affected. At this time, the value of rupee against the US dollar started appreciating alarmingly, from Rs 39-40 in January-February.

    Taking advantage of the volatile situation, unscrupulous foreign exchange traders like foreign banks and some leading Indian banks tried to project in the electronic and print media that in the near future, the rupee would further appreciate, and may soon reach
    Rs 30 to the dollar or less.

    Exporters, including corporate houses, lured by such publicity and fearful of losses, started entering into derivative contracts with banks that had long-term tenure and exposure much beyond this limit.

    As is often the case, the government never allows such appreciation to go on unchecked, beyond a point. So, in reality, the situation started improving as the Indian government started taking steps shortly after the initial scare in 2008, and the rupee started depreciating against the dollar.

    But, fed by scare stories, exporters and corporate had by that time, already entered into derivative contracts with banks, and ended up incurring huge losses. Many small exporters closed down, while shareholders and investors in big corporate houses also sustained huge losses.

    This loss incurred by investors/importers/exporters, based on what they thought was reliable information by the RBI, is nothing short of fraud, influenced by a conspiracy of bankers and other unknown co-conspirators.

    But who gained? The banks selling derivatives say that they are only agents and get a commission in each transaction.

    It is important to note here that whenever a derivative contract is executed for a particular amount, there is a back-to-back contract with another bank in India or abroad. They are called counter parties. The difference goes to counter parties as service charges, at the cost of investors/exporters in India. The RBI clearly admitted that there are large-scale violations of FEMA by banks while dealing with derivative contracts. As has been noted earlier, the RBI admits that due to such actions, the loss sustained by customers do not amount to gain by the bank. It is however not so forthright about the counter parties, the actual gainers, in this case mostly banks based abroad. Could there also have been a concerted effort between these counter parties and the 19 Indian banks to coerce Indian exporters and corporate to jump into these derivative contracts? The way events panned out, it certainly suggest so.

    Moreover, what was the role of the Indian media? Were they also knowingly involved in doing so? In light of the Press Council of India report in 2010 that found a significant section of the media indulging in publishing paid stories, nothing seems impossible in the brave new India.

    Did india’s banks fulfill their fiduciary responsibilities?

    FIDUCIARY responsibilities are the responsibility of a bank to act in the best interests of the depositors. An association of scheduled commercial banks, public financial institutions, primary dealers and insurance companies that represents the interests of the banks allegedly sold illegal forex derivative products to small and medium scale enterprises (SMEs) in dereliction of such responsibilities. The Orissa High Court passed a path-breaking judgment on this issue, in the case of Nahar Industries vs Axis Bank, stating that these cases could not be referred to the Debt Recovery Tribunal (DRT) of India, and should be heard only by the local court having jurisdiction in the matter. It is also hearing the petition filed by the Fixed Income Money Market and Derivatives Association of India (FIMMDA), asking for an RBI inquiry in the case.


    . According to the RBI and CBI’s own submissions, there have been massive violations of FEMA and RBI guidelines

    . Till now, no remedial action has been taken by the RBI and the government to mitigate the situation

    . With the dollar falling again due to inflow of hot money into the stock markets, it is time that government initiated some policies to protect industry from the negative impact of such temporary inflows

    Some larger corporates with huge working capital and separate treasury cells may find derivatives useful (even though companies like Wockhardt in India, and many others abroad have suffered unimaginable losses) but in general, are these products then really of much use in generating competitive advantage for corporates? Do they really help them to operate more efficiently? Products like these are being wrongfully sold to SMEs in particular in India, causing huge problems in industries like textile, pharma. Is it proper to allow sales of such sophisticated and high-risk instruments to SMEs with smaller working capital, jeopardising hundreds of thousands of jobs? Larger questions on the fiduciary responsibility of banks, on allowing leveraged derivatives with unlimited downside to be sold in the country, arise. There are ample examples of banks and countries going down due to ill-advised use of derivative products in the West. Is our country in general and SMEs in particular suitable for sale of such products?

    Banks, the world over, are under scrutiny for their role in recklessly using various derivative products to precipitate crises and profit from it. Recent examples would be the sub-prime crisis in the US that brought the global economy to the brink of collapse, as also the Greek solvency crisis, where credit default swaps (CDSs) were used to profit from the rescue efforts to stabilise and salvage the Greek economy. Is unfettered sale and use of derivative products desirable? In the US and the EU where, incidentally, speculation is legal, lawmakers are bringing about legislations to prevent such incidents from happening in the future.'

    In India, where speculation, especially in foreign exchange, is illegal, and where, according to the RBI and CBI’s own submissions, there have been massive violations of FEMA and RBI guidelines, there has been no remedial action by the RBI and the government to mitigate the situation. Is the well-being of small and medium scale corporates, and the citizens employed in such enterprises, not a matter of concern for the government? Why is it that three years since this crisis broke, a year since the interdepartmental group (IDG) of the RBI made its submissions and findings, no action has been taken to ameliorate the condition of the affected parties?

    With the dollar falling again due to inflow of hot money into the stock markets, isn’t it time that government of India initiated some policy measures to protect industry from the huge negative impact of such temporary inflows? Many countries have initiated policy measures, including taxing such inflows, amongst others, to reduce the attractiveness to speculators, and to encourage long-term investment in the country. What is the Indian government doing?

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    Posted on 19 March 2012



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