Rundheersing Bheenick: Risk mitigation in futures market v/s exposure
to market forces - the EDGE for Mauritius exporters
Address by Mr Rundheersing Bheenick, Governor of the Bank of Mauritius, at the inaugural
seminar of GBOT (Global Board of Trade) EDGE (Empowerment and Development through
Global financial markets' Education), organized jointly with the Mauritius Exporters'
Association, Ebène, 4 May 2011.
* * *
It is an honour for me to have been invited this afternoon to address you on an issue that is
close to my heart. Let me begin by congratulating the organizers, the Global Board of Trade
(GBOT), for yet another excellent initiative, and the Mauritius Exporters' Association (MEXA)
for hosting this event. Any initiative that helps to develop our foreign exchange and
derivatives market will of course receive the full support of the Bank of Mauritius. And for
those of you who may be inclined to believe that dabbling in derivatives by Central Banks is a
risky business, let me assure you that promoting the development of the foreign exchange
market and derivatives is very much part of the remit of the Bank.
On a previous occasion when I had the honour to address a GBOT audience - it was on the
occasion of the Seminar on Currency Derivatives in July 2009 - I had emphasized that
financial development in Mauritius was incomplete and had a long way to go if we are to be
reckoned as an international financial centre. I had then borrowed Randall Dodd's image of a
four-legged table to depict the financial system and argued that our table had one leg
missing. I then welcomed the launch of GBOT, the first Pan-African Derivatives Exchange,
which I believed would play a role in the development of our financial sector and help us to
find that missing fourth leg. Today, I am very glad to note that GBOT has done some brisk
business since its start of operation and its daily trading volume crossed the 50 million
dollarmark two weeks ago. I congratulate GBOT for this achievement and wish them continued
perseverance in the pursuit of their trading volume target of USD 1 billion a day, which I think
is achievable.
On several occasions, in previous addresses and during meetings with various stakeholders,
I have stressed the importance of foreign exchange hedging instruments in helping domestic
corporates, particularly our exporters to manage currency mismatches in their balance
sheets. A typical reaction was: we know how to produce textile products for the markets that
we know - that is our job. We need the dollar at Rs35, the euro at Rs45, and the UK pound
at Rs55 - that's your job! Now, among the tools I discovered when I joined the Central Bank,
unfortunately there was no magic wand... But I believe the debate has moved on a little. I am
very pleased to see that I am no longer a lone voice in the wilderness. I understand that
many of you have started active treasury operations for a more efficient management of your
foreign exchange exposures and the attendant risks that go along. Indeed, GBOT's EDGE
programme aims to support these efforts. The acronym is self-explanatory: Empowerment
and Development through Global financial markets' Education.
I am also aware of GBOT's efforts to familiarize operators with hedging. Much ink has been
spilt on this issue of hedging in the local press in the wake of the unfortunate events at Air
Mauritius and the State Trading Corporation. The airline ran into some unexpected
turbulence, almost bankrupted itself in the process, and ejected management and
boardlevel executives to claw its way back to solvency. Our State Trading Corporation found fuel
imports to be an explosive issue which led to the premature departure of its former Chief
Executive. But abuse, or misuse, of a tool does not make the tool useless. It only underlines
the necessity of perusing the User's Manual very carefully and familiarizing yourself with any
health warning that comes with it, which is the object of this exercise this afternoon. It gives
me great pleasure therefore to reiterate my full support to the EDGE initiative.
As Governor, I have become used, if not inured, to the periodic recriminations of our
exporters on the value of the rupee. There have been times when these were accompanied
by direct threats to phase down operations, to lay off thousands of workers, and cause other
mayhem, if we did not provide relief via currency depreciation. And my unfaltering answer to
them has always been that we are in a free market with no capital controls and the foreign
exchange market is also free. The Central Bank is non-interventionist and when we do
intervene, it is only to smooth out unwanted volatilities, not to achieve any particular
exchange value of our rupee vis-à-vis any particular currency. Hence, taking exchange risk is
very much part and parcel of the game of our economic operators. Since the revolutionary
idea that risk can be managed - which literally transformed the world - man is no longer left
to the whims of the gods. The concept of management of risks actually drives modern
society, and much of the progress made by man would not have been realized without the
notion that risk not only can be managed, but can actually be rewarding. Indeed, risk and
reward are the two faces of the same coin.
The exporters' outcries show their extreme vulnerability to the vagaries of global financial
markets. At the same time they reflect a certain inability, or should I say reluctance, to seize
the opportunity that modern risk management tools offer to mitigate their risk. I do
understand your fears - trading in derivatives is quite complex and involves many risks. The
memories of the collapse of Barings in 1995 and the more recent scandal at Société
Générale in 2008 are still fresh in the minds of many people. These scandals have nourished
the myth surrounding derivatives and their potential for leading to catastrophe. In both these
cases, as indeed in the more recent cases like Bear Sterns and Lehman Brothers, the
problem was not with the derivatives but with the controls those banks failed to put in place.
And there was also a failure of regulation and supervisory oversight.
Today, we are here to talk about risk mitigation through the futures market. Some corporates
in Mauritius, as well as the Mauritius Sugar Syndicate, have traditionally hedged their foreign
exchange exposure using forward instruments traded in the over-the-counter market. It is
good to know that futures and forwards contracts are both contracts to deliver an asset on a
future date at an agreed price but they differ in some respects. Futures are standardized and
exchange-traded, while forwards are customized and traded over-the-counter. Thus futures
face an exchange, while forwards face a non-exchange counterparty. Furthermore, futures
are often margined, while forwards are not. They have significantly less credit risk, and their
funding is different.
Like the forward contract, a futures contract is a guarantee that a certain product will be sold
at a fixed price at a certain date. Although the proliferation of mysterious-sounding acronyms
and the complex trade jargon may indicate a recent origin, the concept is certainly not new.
In fact the idea of entering into agreements to guarantee a fixed return in the future is
mentioned by Aristotle. Gillian Tett, in her fascinating book "Fool's Gold", drawing on the
aforesaid Randall Dodd, tells us of rudimentary futures and options contracts having been
found on clay tablets in Mesopotamia, dating back to 1750 BC. The first futures exchange
market was the Dōjima Rice Exchange in Japan in the 1730s, to meet the needs of samurai,
who were being paid in rice and needed a stable conversion for the value of their currency
which was the rice. The first-ever standardized "exchange traded" forward contracts, called
futures contracts, were listed in 1864 by the Chicago Board of Trade, or C-BOT - surely the
inspiration for G-BOT, our host today. Soon there were contracts created on a number of
commodities, and futures exchanges developed all over the world. This was the birth of our
modern futures market as we know it. Today, there are more than 90 futures and futures
options exchanges and these include the London International Financial Futures Exchange
(now Euronext.liffe), Deutsche Terminbörse (now Eurex) and the Tokyo Commodity
Exchange (TOCOM).
With the breakdown of the Bretton Woods system of fixed exchange rates, deregulation, and
the advent of new technologies, the environment, in which banks and other financial
intermediaries evolved, changed drastically. They responded by developing financial risk
management products designed to better control exchange risk. They started with simple
foreign exchange forwards that obligated one counterparty to buy, and the other to sell, a
fixed amount of currency at an agreed date in the future. By entering in such contracts,
customers could offset the risk that large movements in exchange rates could adversely
impact the economic viability of their transactions. The World Bank, one of the Bretton
Woods twins, concluded the world's first swap deal in 1981, with IBM as the counterparty
and Salomon Brothers as the arranger. Where Salomon Brothers led, others followed, piling
innovation on innovation. An ever-increasing number of novel products designed to manage
and control financial risks more effectively were gradually offered to customers. There is
today an impressive array of financial risk management products available.
When we compare the stage of development of our financial sector with that of the
developed economies, or even with a few other emerging economies, it is evident that we
are trailing quite far behind. India, for example, has a deep and liquid equity spot and
derivatives market, a liquid forex OTC spot and derivatives market, an exchange traded
currency futures, a market for Government securities, an interest rate swap market, a
securitization market, a primary market for corporate bank and money market instruments,
and a repo market in Government securities and corporate bonds. We are indeed trailing
very far behind, aren't we? But, by way of mitigation, I have to point out that the Indian
exchanges remain largely domestic given that capital controls still exist there. Our banks deal
very little in forward transactions and even less in options. We only have a thin spot market
that does not offer adequate protection to our operators against the volatility of the dollar and
the euro.
If our system is still deficient, it is certainly not through want of trying. We have spared no
effort to put in place the appropriate infrastructure to deepen the financial system. The
enabling legislation has been put in place; there are continuing efforts at the Bank to develop
a secondary market for Government paper; there are other initiatives by the Stock Exchange
of Mauritius; and we have GBOT, the exchange which is hosting this event this evening. In
December 2009, the Bank initiated foreign currency swaps tailor-made for the needs of our
export operators when there was evidence that the volume of transactions on the domestic
spot foreign exchange market had declined, and was causing some undue volatility in the
market. This measure had a two-fold objective: first, to cater to the needs of the operators
temporarily, and second, to encourage them to have greater recourse to hedging instruments
for securing their rupee earnings. Although we maintained the swaps throughout 2010, they
have not been used since July of that year. Participants still show reluctance to hedge their
exposures - it is not easy to get rid of old habits.
Most of the time, our exporters have evolved in a fairly well-protected market; they have
developed a reliant client-base in Europe, and they relied on the expected depreciation of the
rupee to sustain their operations. There was no need for them to have recourse to hedging
instruments to control their risks. Well, as you all know, that era is over. Today, there is not a
single exporter in this room who does not believe that the economic viability of his enterprise
depends on the proper management of its risks, or to put it differently, there is not a single
exporter who believes he can ignore developments on the currency front and his business
will still flourish. Let me bring up some statistics to highlight the importance of the
exportoriented sector in the Mauritian economy and the extent to which they are exposed.
The EOE sector plays a key role in our economy and its sustainability and competitiveness
are a matter of national interest. To take 2010 figures, the EOE sector represents around
6 per cent of GDP, accounts for 58 per cent of total export of goods, and provides
employment to nearly 56,000 persons, which in turn represents a little over 10 per cent of
total employment.
However, the EOE sector and external demand-led sectors as a whole are subject to some
structural weaknesses which make them particularly vulnerable to external shocks. A full
two-thirds of our total export of goods was directed to European markets in 2010. This
pattern of dependence on Europe is also evident on the services front. Two-thirds of our
tourists also come from Europe. To complete the picture, half of total FDI inflows into
Mauritius came from Europe in 2010.
This geographical concentration on Europe for exports of goods and services, and inward
investment, is not replicated on the import side. Europe provided only one quarter of our
imports of goods. We are not only highly exposed to the European market; we also have to
cope with the imbalance in the currency in which our trade is conducted. On the one hand, it
is estimated that 41 per cent of our export proceeds is denominated in euros. The share of
the US dollar and pound sterling stands at 39 per cent and 14 per cent, respectively. On the
other hand, our imports are invoiced mainly in US dollars, with a share of 67 per cent. The
euro represents 21 per cent and the pound sterling less than 2 per cent of imports.
At one point in time, the combination of a downward slide of both the euro and the pound
sterling on global currency markets, coupled with a stronger US dollar, raised serious
concern in view of the negative implications of such a trifecta on a wide spectrum of
economic activity in the country, including the sugar, textiles, tourism and BPO sectors.
Today, fortunately the rupee has stabilized. We cannot, however, pretend that we are
protected from all external instability, as the value of our currency in the domestic foreign
exchange market is largely driven by the interplay of domestic and international factors. After
almost 84 weeks of non-intervention in the foreign exchange market, the Bank started
intervening again to correct emerging distortions in the market. So while we, as regulator are
playing our part to stabilize the market, you exporters, who are the active participants, are
also expected to play yours. You cannot continue to take one-way bets on the exchange rate
or continue to try to pull the rug in your direction. It will come as no surprise to close
observers of the Mauritian economic scene that, in its last Article IV Consultation Mission
conducted early this year, the IMF finds that our currency is broadly in line with economic
fundamentals. So let's stop griping about rupee strength or weakness and take action to
minimize currency risks.
I have every reason to believe that our operators are beginning to appreciate fully the
importance of managing their foreign exchange risk - the organization of this seminar with
the support of MEXA, the exporters' association, and the high turnout, are ample evidence of
this. 2010 has been a very good year for our exporters in spite of the fragile recovery in our
main export markets. Exports by EOEs rose by 11 per cent in 2010, nearly four times faster
than the 2.8 per cent growth of 2009. The seafood sub-sector is said to be hauling in a very
good catch and the textile sector remains stable, with full order books and recovering
markets.
However, we are conscious that the export sectors are facing daunting challenges in the
wake of the uncertainty still surrounding the global economic environment, and, in particular,
our main export markets. From our perspective, risks of subdued growth surround these
traditional partners, although there are new opportunities arising in other parts of the world.
But it is evident that now is the time, more than ever, for our export operators to rethink their
business models to adjust to the new economic order. Now, more than ever, is the time for
them to re-engineer their operations, achieve sustained rises in productivity and move into
new products and new markets! Salvation can only come from diversification. Geographical
diversification, sectoral diversification, and product diversification. Diversify, Diversify,
Diversify - that should be our new mantra. This is more of a medium-term challenge though;
the simplest way to start is to learn how to properly manage your foreign exchange risk and
this is what you are here for today.
Let me briefly comment on some misconceptions on the use of derivatives. There are indeed
many old wives's tales about derivatives, and believing in the fairly widespread myths may
lead people to avoid them altogether. That would be a mistake. It is true that the tremendous
growth of the derivatives market and the reports of major losses associated with derivative
products have created a lot of confusion about those complex instruments. Derivatives have
been considered as the villains in the collapse of the global financial system. In fact,
companies and countries that bought derivatives in the form of mortgage-backed securities,
credit default swaps and synthetic collateralized debt obligations as insurance, discovered, to
their dismay, that the insurance cover was only as good as the counterparty at the other end
of the contract. Some were of the view that the problem was not so much with the exotic
nature of some of the products, or their volume, as with the fact that the derivatives were
traded over the counter, that is, outside a transparent and regulated exchange. That is how
the value of OTC derivatives reached ten times global GDP. Others blamed the lax
regulation of financial derivatives and perverse incentives. This is why there are proposals on
the table on either side of the Atlantic for the better regulation of all derivatives trading.
Essentially what derivatives do is to hedge risks by reducing future uncertainties and
managing them more effectively. Derivatives help to improve market efficiency because risks
can be isolated and sold to those who are willing and able to accept them at least cost. But
using derivatives requires a firm understanding of the tradeoff of risks and rewards, and the
decision to use them should be driven by the participant's strategic objectives. It is important
that all users understand how their contracts are structured, the unique price and risk
characteristics of those instruments, and how they will perform under stressful and volatile
economic conditions. Derivatives users should establish a framework for effectively
managing and controlling derivative activities. The dark side of derivatives is that, if they are
used improperly or without a plan, they can inflict serious losses. So without a clearly defined
risk management strategy, the use of derivatives can be dangerous. When used wisely, they
can increase shareholder value by providing a means to better control a firm's risk exposures
and cash flows. A firm should be clear about the risks it is comfortable with, and the risks it
does not want.
Now that we have an exchange where currency futures can be traded, new opportunities are
opened to investors. Besides offering better price discovery and lower transaction costs, the
futures market is a major financial hub which provides an outlet for intense competition
among buyers and sellers and, more importantly, a center to manage price risks. It is also a
very liquid market. Currency prices are based on objective considerations of supply and
demand and cannot be easily manipulated because the size of the market does not allow
even the largest players, to move prices at will. Futures market prices depend on a
continuous flow of information from around the world and thus require a high amount of
transparency.
It is an indeed very exciting time - watching the developments, albeit small, that are taking
place in our financial system. We hope that after a few such training sessions we will soon
see our exporters proactively seeking ways to hedge their risks. We have an exchange in
Mauritius which is properly licensed and regulated, where there is price transparency. I can
only encourage our operators to participate in it. GBOT currently offers gold and silver
contracts and futures in five currency pairs: EUR/USD, GBP/USD, JPY/USD, ZAR/USD as
well as USD/MUR. I have no doubt the exporters will find among these, the instruments that
would most suit their needs. May I add that the Central Bank is also closely monitoring the
currency trading. Since the start of operations until the end of April, the total turnover of
transactions in the various currency pairs conducted by GBOT add up to nearly
USD 1.4 billion. So far, so good, one may be tempted to say. But what is far from good is that
trading in the rupee-dollar currency pair came to a grand total of less than USD 1 single
million! There is considerable room for improvement, isn't there?
We will continue to support the development of professional training courses and investor
education programmes to deepen expertise in the sector. One example of such training is
the OptionsXpress® Investor Education Series of the Chicago Mercantile Exchange on
futures options and which had the slogan: "Get your feet wet before you take the plunge". I
do believe this is what our exporters are precisely here for - to get their feet wet. It is
important that you have a proper knowledge of the product and an understanding of the
arithmetic of its leverage - which I am sure, should help dispel much of the mystique
surrounding the world of derivatives. You should not overlook your treasury operations. This
reminds me of General Motors (GM), the renowned US car maker which founded in 1919 the
General Motors Acceptance Corporation (GMAC) to provide financing to automotive
customers. Over the years, GMAC expanded to include insurance, online banking, treasury
operations and so forth; it was at some point in time making more profits than GM itself.
Eventually it applied to the FED to become a bank holding company and changed its name
to Ally Financial Inc in 2010. I am not telling you that you need to go that far - by all means,
do not stray too far from your core competencies or, put differently, stick to your knitting! But
you should not overlook the importance of proper treasury operations and greater use of
derivatives products that are now available to you. It might bring in some additional profits.
Let me now conclude with a word of caution for the banks and foreign exchange dealers who
are to be the main players in this game - the absence of robust risk management practices
and adequate oversight surrounding this activity could have disastrous consequences. Banks
and foreign exchange dealers should therefore ensure that their dealers are well trained, that
there are clear-cut controls on their operations, and at least in the initial stages that the
activities are audited on a concurrent basis. While the exchange has the responsibility to
ensure against settlement risks, it is the institutions concerned that have to address internal
procedural issues. We, the regulator, expect to see among all participants unrelenting
emphasis on efficient risk management infrastructure. We encourage the ongoing
development of a qualified talent pool with deep knowledge in the area, who will uphold
proper market conduct. We intend also to maintain a close dialogue with all relevant
stakeholders to ensure a robust and conducive regulatory environment for the development
of a vibrant futures market in Mauritius.
Whether you are reaching out to new markets, branching out into new products, or
envisaging greater recourse to derivative products, it is change that is the order of the day.
"It is not
And I am reminded of Charles Darwin's conclusion from his great study of species:
the strongest of the species that survives, nor the most intelligent, but the one that is the
most responsive to change".
I wish you all a very fruitful seminar.
Thank you for your attention.