India felt bolts of the sub-prime crisis

The notion that India’s conservative approach protected it from the sub-prime crisis of 2008 is not exactly true, for American and European banks were able to pass the crisis to the extent of at least Rs32,000 crore, according to documents with DNA.

They did so by selling illegal exotic derivatives to Indian companies in 2007-08. Such contracts were sold by foreign bankers (the RBI on April 27, 2011, had fined 19 banks, which includes foreign banks such as Deutsche Bank, Calyon Bank, JP Morgan, Standard Chartered, Citibank and Societe Generale and ABN Amro, and domestic banks, such as SBI, ICICI, HDFC, and Axis for flouting rules).

A development research group report by the RBI indicates foreign banks’ involvement. “With the volatility in currency markets and steep depreciation of rupee in 2008, many Indian firms lost money. Many such deals (sale of exotic derivatives) were signed where Indian banks were often a front for foreign banks,” the report said.

Derivatives are financial products with value that stems from an underlying asset or set of assets. In this case, as it relates to foreign exchange and interest rates, it refers to option contracts on exchange rates (rupee-dollar, dollar-yen, dollar-euro, etc) or interest rate swap contracts (dollar-Libor, yen-Libor or other floating index ).

Exotic derivatives have features that make them more complex than plain vanilla derivatives in terms of pay-offs. Banks in India hard sold these ‘structures’ to gullible companies for significant profits. The companies who bought them did not understand the magnitude of the risks they were taking or the fair value of the contracts they were entering into. In addition, as they did not understand it, in most cases they were speculating on interest rates and exchange rates instead of hedging the underlying risks.

Usually, under these agreements, one currency is bet against another. In the exotic derivatives sold to Indian companies, US dollar (base currency) was bet against another foreign currency (usually euro, yen or Swiss franc). In these deals, traders would have gained a fixed amount, but loss was indefinite.

These contracts were sold on the assumptions that certain currencies like Swiss franc, euro and yen would remain constant or depreciate against the US dollar.

Had this happened, these deals would have been in favour of the companies. However, when the sub-prime crisis began, major currencies appreciated against the US dollar resulting in huge losses to the Indian companies that had signed up for these deals.

For instance, in one of the cases, an exporter was expecting to gain at most Rs3.5lakh if the dollar moved up against the euro, as per the contract. However, when the dollar fell against the euro, due to the sub-prime crisis, it resulted in a loss of Rs2.3 crore, which is 67 times the maximum profit the exporter could have earned.

When, during the crisis, the rupee rose rapidly to Rs39 from around Rs50, expectations were that the rupee would rise to as much as 32 per dollar.

During this time, many banks in India started aggressive marketing of exotic derivative contracts projecting them as an alternative profit-making mechanism available to exporters. The exporters/companies signed these contracts expecting to make good losses incurred due to a fall in the rupee-dollar exchange rates.

Banks that sold the derivatives needed a back-to-back contract with other overseas banks, said a preliminary report submitted by the Central Bureau of Investigation to the Orissa high court.
The report was submitted after a public interest litigation (PIL) was filed with the high court in 2009 seeking CBI’s intervention in the issue. “Therefore, the losses suffered by Indian companies do not reflect the profits made by the banks,” it added.

The investigating agency’s report is a clear indication that the money has gone abroad, said Manoj Mishra, an advocate who has filed the PIL.

Corroborating CBI’s report is an IMF report, which says big foreign banks in the US and Europe were able to transmit the financial crisis to emerging economies like India, China, Japan, South Korea and others by fleecing about $530 billion (approximately Rs26,50,000 crore) through the sale of exotic derivatives in these countries. DNA has copy of both the reports.

“An international pattern of exotic derivatives trading appears to have helped transmit the financial crisis from the US and the European Union to many different emerging market economies… Possibly 50,000 firms in at least 12 economies have suffered derivatives losses,” says the IMF report. The CBI report cites the same.

Experts believe that the aggregate loss on exotic derivatives could be more than Rs80,000 crore. “The Rs32,000-crore figure is the loss suffered till December 2008 on contracts with one-year maturity. However, there are many contracts with maturity period of two to three years. This will amount to a higher loss that could be around Rs80,000 crore,” said S Dhananjay, a chartered accountant in Tirppur, Tamil Nadu.

“Looking at the magnitude of the scam, it seems that investment banks in US that could foresee sub-prime crisis infused exotic derivatives in emerging economies to reduce dollar exposure,” said Mishra. He opines that RBI was well aware of all these happenings, as so many banks selling similar kinds of derivatives at the same time cannot be a coincidence.

“Indian public sector banks, which had little or no knowledge of exotic derivative deals, were taken for a ride by the foreign banks through presentations in 5-star hotels in India and abroad, and convincing dealers (banks) that there can hardly be any losses in these deals,” said a former employee with a leading public sector bank, Rajesh Goyal, who has worked for more than a decade in that bank’s treasury department.

Such deals were offered without any security ie corporates were not required to pay anything upfront, Goyal added. One can say that it is similar to the sub-prime mortgage crisis, where loans were given without scrutinising the ability of the customer to pay off.

The IMF report says, “Although the names for the exotic derivatives varied from country to country, the basic economic structure of the transactions remained the same.” The IMF says it spotted the pattern when many unrelated instances of firms from various countries reported derivatives losses, which were huge enough to have financial market and macroeconomic consequences.

Considering the reports of RBI and CBI’s submission to the Orissa high court, which did not rule out the possibility of “cheating, criminal conspiracy and fraud”, the matter needs to be investigated, said RP Luthra, advocate with the Delhi high court.
Until now, RBI has not shared information on the overall issue. In response to an RTI query seeking details on the total outflow of foreign exchange on account of derivatives during 2007-2010, RBI said it does not have any information.

“How is it possible that RBI does not have information on money gone out of India? The rules say that aggregate trade data relating to all derivatives must be reported by banks to RBI on a regular basis. It is well evident that the central bank is trying to hide the information,” said Vinod Kothari, a Kolkata-based chartered accountant. RBI did not reply to the queries sent via e-mail by this newspaper.

In some cases, the net worth of a company was much below the losses incurred by them. Many of these companies took banks to court, alleging they illegally sold these exotic products. Orissa high court then directed the CBI to investigate the matter. However, Fixed Income Money Market Derivative Association of India (FIMMDA), an association of banks dealing with foreign exchange, challenged the decision in the Supreme Court.

Several banking establishment in the country, such as Indian Bankers Association, Foreign Exchange Dealers Association of India and even the Reserve Bank of India, have joined the FIMMDA before the SC as interveners to avoid the CBI probe. “It seems the RBI is keen to defend the bankers’ action, which is almost like self-defence. Because if the courts hold that the bankers have gone wrong, it would be largely due to lapses on RBI’s part,” said Kothari.