The Hidden Costs of Currency Volatility Management

Leap Editorial Team
5 February, 2025

The Hidden Costs of Currency Volatility Management: Understanding India's ECB Exposure

Recent data from the Reserve Bank of India (RBI) reveals a concerning trend: approximately 34.4% of External Commercial Borrowings (ECBs), amounting to $65.49 billion, remain unhedged. This significant exposure, particularly among non-banking financial companies (NBFCs), raises important questions about the relationship between central bank intervention and corporate risk management behavior.

The Paradox of Volatility Management

The RBI's active management of currency volatility, while intended to promote stability, may paradoxically be encouraging risky behavior among market participants. When central banks aggressively manage currency fluctuations, they create an artificial environment of low volatility that can lead to systemic complacency among borrowers.

This phenomenon creates a dangerous cycle:

1. The central bank's intervention reduces currency volatility

2. Companies interpret this stability as a permanent feature of the market

3. Businesses become less inclined to hedge their foreign currency exposure

4. Unhedged positions accumulate, creating potential systemic risks
Market Participant Perspectives

Companies typically adopt one of two viewpoints regarding currency stability:

1. A belief that the RBI will perpetually maintain rupee stability

2. A more nuanced understanding that compares INR movements with other emerging market currencies and recognizes the limitations of central bank intervention given global dollar movements

The second perspective acknowledges an important reality: periods of low volatility often build up pressure for future currency adjustments. The apparent stability in currency levels during low-volatility periods rarely represents a true equilibrium state.

The Hedging Divide

This market dynamic creates a significant divide between companies:

• Resourceful firms with strong balance sheets recognize the risks and maintain hedging practices

• Financially weaker entities often find justifications to avoid hedging, leaving them exposed to currency risks

Interestingly, hedging costs themselves respond to these dynamics. During periods of low volatility, forward premiums typically decrease, theoretically making hedging more affordable. However, this cost advantage is often overlooked by companies that have grown complacent due to the perceived permanence of currency stability.

Policy Implications

This situation suggests that central banks might better serve market stability by allowing for more natural currency volatility. When volatility is artificially suppressed, it doesn't eliminate currency risk -- it merely masks it, potentially leading to larger, more disruptive movements when adjustments eventually occur.

The key lesson is that some level of currency volatility serves as a healthy reminder of underlying risks, encouraging more prudent risk management practices among market participants. By allowing for measured volatility, central banks might actually promote more robust and resilient financial markets in the long run.

References:

1. Reserve Bank of India (2024). Financial Stability Report, December 2024. Reserve Bank of India, Mumbai.

2. Patnaik, I., & Shah, A. (2010). Does the Currency Regime Shape Unhedged Currency Exposure. Journal of International Money and Finance, 29(4), 760-769.