Knitwear exports from Tirupur have grown from Rs 15 crore in 1985 to over Rs 10,000 crore now — a stupendous feat achieved by home-grown entrepreneurs, through competitive churning within. But the fall of the dollar saw a downturn in their fortunes that has been exacerbated by losses suffered from complex forex derivatives, says S. GURUMURTHY.
The novel-like prologue is inevitable. ‘Armstrong’ Palanisamy is a typical home-grown entrepreneur in the global knitwear hub of Tirupur. A farmer’s child, he was on the field and also at school, more in that order.
But, like many in Tirupur then, he too failed in his Pre-University Course. In the mid-1960s, he joined a knitwear unit in Tirupur. Like for most, for him too, it was an open-air MBA course in the knitwear business.
Soon, like his peers, he started his own knitwear work. At that time Neil Armstrong had landed on the moon. His name was on everyone’s lips, including in Tirupur.
Armstrong brand
So, the new entrepreneur, keen to penetrate the US market, branded his banians and T-Shirts as ‘Armstrong’. And, soon, he himself soon got branded, after his product, ‘Armstrong Palanisamy’. But he is no anecdote. He is a sample of the now globally-known Tirupur entrepreneurs.
Hundreds like him, big and small, had sprung up in Tirupur in just two decades. Dr Sharad Chari, in his meticulous research titled Fraternal Capital: peasant-workers, self-made men and globalisation in provincial India (Stanford University Press), traces how most entrepreneurs of Tirupur belong to one community — Kongu Goundar.
The science of their massive progress as a group is this: contagious competitive spirit forced one to copy, compete with, others within the community, turned into a sociological mix of business rivalry and fraternal co-operation that triggered an exponential entrepreneur development model in Tirupur. This is a subject in itself.
‘Social capital’
This is how the Tirupur entrepreneurs evolved: from cotton farming to cotton ginning, ginning to spinning, spinning to knitting and finally as knitwear exporters, soon to became a global brand.
The World Bank took the Goundar community by name in the World Development Report 2001 and noted its rise as a global knitwear force by leveraging on its own internal strengths as a community — read ‘social capital’ — often derided as caste.
The Bank also discovered how the Goundars had relied on their traditional networks, not on modern banks, to circulate their savings within to find and fund the capital they needed.
The Goundars graduated as entrepreneurs, not from IIMs, but by the contagious competitive churning within.
Sharad Chari’s painstaking work points out that two-thirds of the knitwear makers, like Armstrong Palanisamy, are matriculates or less, with only a third having been to college, and none — yes none — professionally qualified, thus pointing to the inverse relation between education and entrepreneurship.
Export growth
Knitwear exports from Tirupur have grown from Rs 15 crore in 1985 to over Rs 10,000 crore now! The liberalisation of the forex sector and the zeal to depreciate the rupee to make exports cheaper, saw the dollar appreciate and the rupee fall, by some 450 per cent in a decade. This put Tirupur on a growth escalator.
Knitwear exports from Tirupur rose as the dollar strengthened against the rupee from some Rs 13 to a dollar in 1991 to some Rs 50 in 2002-03. Subsequently, the dollar began slipping against all currencies and also, but less, against the rupee, thanks to the RBI’s policy to keep the rupee cheaper.
In the early months of 2007, the dollar was ruling at some Rs 44. Till then everything was going well for Tirupur exporters. But the history reversed from April 2007 onwards. A dollar of export, that fetched Rs 44 in March 2007, slipped to almost Rs 40 in just four months. The exporters lost thus.
If, in March 2007, an exporter had contracted to deliver 1,00,000 T-Shirts at $5 a piece in June 2007, his export bill would be $500,000, which at Rs 44 a dollar would get him Rs 2.20 crore on delivery. But as the dollar had fallen to Rs 40 by June, he would get less, only Rs 2 crore! With the annual exports in Tirupur being $2.2 billion, at any given time the knitwear under delivery or pending for payment would be more than $750 million, or Rs 3,300 crore.
If the dollar fell from Rs 45 to Rs 40, their loss would be Rs 300 crore. And expecting that the dollar would go up, not come down, many had kept the sale income already received in dollar account which also depreciated when the dollar collapsed in April-June 2007. The estimated loss of Tirupur exporters due to the dollar fall was estimated at Rs 400 crore.
Forex derivatives
Now begins the story. When the Tirupur exporters stood perplexed by the sudden and unexpected, adverse turn of events, a set of banks, most of them the new class of private banks, sent their most articulate and modern forex derivative salesmen to the simple-minded exporters. They unveiled before them a magic safety net.
They counselled the knitwear exporters not to think that they could make money only by exporting knitwear — a hard task — and told them that they could earn more, and easily, by playing in the forex market through derivative products. They assured them that the income they earn by buying and selling the forex derivative products would more than compensate them for their losses due to the dollar fall. These banks did not confine themselves to Tirupur. They went to every such community-led industrial cluster — Ludhiana, Surat, Rajkot, Baroda, Coimbatore, Tirupur, Karur.... But this story is about Tirupur.
The exciting prospect held out by the enterprising bankers was music to the ears of the desperate exporters. The banks had also told them that the derivative products had been devised by Nobel Prize winning economists! For the Armstrong Palanisamys of Tirupur reeling under the pain of the dollar fall, it was too tempting a relief. What is a forex derivative?
Stated in less complex terms, the forex derivatives marketed in Tirupur are a bet like any other bet. Here the bet is about whether the euro or yen or Swiss franc or French franc would rise or fall against one another and/or against the dollar and by what margin they will do so. If the bet goes right the exporters gain; if it goes wrong, they lose. The best financial brains cannot predict who would win the bet or lose.
Says www.finpipe.com , a Web site dedicated to promote knowledge of derivatives: “Politicians, senior executives, regulators and even portfolio managers have limited knowledge of these complex products.”
Buffet-speak
This is not in Tirupur or Ludhiana but in the West where derivative products are traded like bananas. Yet, Warren Buffet, the world’s richest and also the most accomplished financial brain, fears derivatives as financial WMDs, that is, weapons of mass destruction.
Some derivatives, says Warren Buffet, seem to have been devised by ‘madmen’. If Buffet is scared of derivatives and sees them as madmen’s game what would the exporters of Tirupur, who are ex-farmers, and two-thirds of whom are matriculates and less, know of derivatives, is obvious.
Even as the banks sold complex currency derivative products — feared by Warren Buffet as WMDs — to Armstrong Palanisamys, they knew that the uninformed buyers of their new wares were unaware of the consequences of playing with the new, enchanting toys.
The alluring assurances by banks persuaded the Tirupur exporters, given to herd mentality, en masse to sign up and buy the magic derivative products running into hundreds of millions of dollars, which they were told, and they believed, would relieve them of their sudden losses.
In the first few derivative dealings, the derivative merchants did manage to credit some profits to the exporters, which lured them even more to the new toys. Thus, from April 2007, the slick merchants of derivatives sold hundreds of millions of derivative-wares in dollars, euros, pounds, Swiss francs, Japanese yen paired in different mixes.
Increased risk
These derivatives were not devised to hedge the exporters’ risk, but to yield profits to them. And, therefore, they increased the exporters’ risks and exposed them to losses that were multiples of the losses occasioned by fall in the dollar value. Take the case of Armstrong Palanisamy. By about March 2008, the banks began asking him to pay — believe it! — over Rs 30 crore as loss on the derivative products sold to him on which he was, at the start, assured of adequate profit to offset his loss of some Rs 3 crore on dollar fall!
Thus the derivatives multiplied his woes. Most exporters of Tirupur suffered Armstrong Palanisamy’s fate, with some hit by more, and some by less, losses. The derivative loss of Tirupur is estimated at Rs 500 crore. This is in addition to their loss due to the dollar fall. Now comes, the next part, the story of how the derivatives that are intended to protect turned destructive to Tirupur.
The derivatives products merchanted by banks to the Palanisamys of Tirupur are known in forex trade as ‘exotic’. ‘Exotic’ means “strangely beautiful, enticing” also used as an adjective in ‘exotic dancer’ that is, “belly dancer, or the like”. The word ‘exotic’ as prefix to the derivatives poignantly captures how Tirupur’s exporters must have been mesmerised by the banks, rather like teenagers by stripteases and belly dancing.
As a curtain-raiser to how the Tirupur exporters were lured into exotic derivatives, here are some tips on forex derivatives. A derivative is a hedge against a risk; the hedge protects ‘against a fluctuation in the foreign exchange rate, rather than profit from it’.
Experts assert that currency laws in India allow hedging to avoid losses, but not to make profits. Derivative structures that yield profits are void, they say. Where do the Tirupur derivatives stand in this view of law? Start with the forex forward contracts, an undoubtedly permitted hedge. It works thus.
If a Tirupur knitwear maker commits to export when the rupee is, say, 41 to a dollar, he may forward-sell his export income in dollars at Rs 41 so that even if the dollar falls later to, say, Rs 39, the exporter will still get Rs 41. This is known in forex trade as ‘vanilla’ or plain forward, which hedges the risk of fall in forex.
But the derivatives merchandised by the banks to the Tirupur exporters were not that simple. A brief survey of the Tirupur derivatives shows that they were complex, exotic derivatives or seemingly simple ones but not allowed in law.
First, complex exotic derivatives were sold to the unwary exporters, most of them matriculates or school drop-outs, in what is clearly an exercise in deception. Even the most accomplished financial minds cannot fathom such derivatives.
Bewildering jargon
Here is an example of the complex derivatives hawked on Tirupur’s streets in the second and third quarters of 2007. Beware. The next few lines will spin the mind. An illustrative derivative deal dated July 3, 2007 (with ‘Tokyo cut’ ‘European style option’ and ‘American barriers’ as features) expiring on May 23, 2008 reads: “The exporter buys (and the bank sells) USD Call/CHF Put at strike 1.2300 for USD4 million with Knock Out @1.2400; The exporter sells (and the bank buys) USD Put/CHF Call at strike 1.2300 for USD8 million with Knock Out @ 1.24, Knock In @1.12”; “Double One touch option with trigger 1.2270 and 1.2330 with pay off USD 50000 on maturity”
Option legs? European style? American barriers? Tokyo Cut? Double one-touch option? Knock In? Knock out? How would the school dropouts-turned exporters in Tirupur have grasped these bizarre terms? Its effect, which even some experts cannot easily comprehend, is this: (a) if the Swiss Franc (CHF) trades at 1.2270 or 1.2330 to the dollar during a term of the derivative, the exporter would get $50,000 (equal then to Rs 22.5 lakh); (b) if the Swiss Franc trades below 1.12 to the dollar, the exporter is obliged to buy $8 million at 1.23, and incur a loss of $880,000, or Rs 4 crore, which will multiply if the dollar falls, as it actually did, below 1.12 Swiss Franc.
The dollar dipped as low as 1.05 Swiss Franc in May 2008. Every cent’s rise in the Swiss Franc against the dollar meant a loss of Rs 36.37 lakh to the Tirupur exporter under the deal. The Swiss Franc rose by 18 cents, and caused a loss of Rs 6.57 crore to the exporter’s acccount. What excited the exporter was the prospect of a small gain — Rs 22.5 lakh — the belly dance of the exotic derivative.
The law says that such profit-making is illegal, but the banks lured the exporter into the deal by simply dangling this illegal lollypop! QED: the exporter’s profit is limited to $50,000; his losses, unlimited in the deal.
Risk multiplied
Second, the banks advised the Tirupur exporters to go for derivatives that multiplied, not mitigated, their forex risk. In the illustrated case again, not one but three banks — one foreign, another feigning as Indian, and the third, nationalised — had marketed various combinations of derivatives to the same Tirupur exporter during 2007.
Under those derivatives, the exporter effected net purchase of $62.5 million and net sale of other currencies — Euro 6.75 million, GBP 27.75 million, Japanese Yen 167.12 million, CHF 1.10 million, and Rupees 63.95 million. While the three banks had forward-sold to him $62.5 million, he actually needed to sell — not buy — USD, as 90 per cent of his exports were billed in USD.
Here, the purchase of $62.5 million increases, not hedges his risk. The law says that banks should not, by the options they offer, increase the risk of the exporter. Yet this is precisely what the banks have done in Tirupur.
Imagine that a derivatives expert gives unsolicited advice to an uneducated mango-grower not to sell his mangoes in forward but go more for mango deriatives! How criminal would such advice be? The banks’ advice to the ex-farmers of Tirupur, who were generating USD through knitwear exports, to buy more USD was no different from such advice to mango-growers.
Third, the derivative volumes in most cases in Tirupur are many multiples of an exporter’s actual export turnover, while the legal cap for derivatives is only a fraction of it. The illustrative knitwear producer’s average exports for the last three years was $8 million, which is the cap on derivatives. Against this limit, the banks had contracted derivative volumes of $62.5 million — nearly eight times the limit.
A caveat. This limit is applicable only to hedging against losses; not to the purchase of $62.5 million which is not a hedge, but, a pure bet on the dollar. More. The law insists that three-fourths of the contracts for the permitted $8 million are not cancellable and have to be on deliverable basis. Yet all the deals contracted by the three banks were intended to be cancelled, settled without delivery!
Non-deliverable forwards
Fourth, under the deals marketed by them, the banks had contracted to buy specified currencies from exporters in which they had not billed and, therefore, would not get payment.
In the instant case, the three banks had contracted to buy 6.75 million Euro, 27.75 millions GBP, 167.12 million Jap Yen, 1.1 million CHF, from the exporter when he will get or have no Euro, no GBP, no Jap Yen and no CHF to sell, as he has billed his exports in USD and not in those currencies. Where from, then, will the exporter get the Euro, GBP or CHF to deliver to the banks?
The banks knew at the outset that they were not to deliver; so the banks have marketed non-deliverable forwards, not permitted in law. There are at least hundred such cases, big and small, like this in Tirupur alone.
Fifth, under the law, only the bank with which an SME (small and medium enterprise) has regular banking can offer derivatives products to it. And, that too, if the bank is satisfied, after conducting a due diligence check, that the kind of derivative is suitable to the client.
More, globally accepted norms require the banks to offer only derivatives suitable and appropriate to a customers, big or small. The Tirupur exporters are SMEs. Yet, in most cases, the derivative sellers were not the regular bankers of the concerned exporters. And no due diligence exercise was undertaken to assess the suitability of the product to an exporter.
It is not that the Tirupur exporters went to the banks in search of these complex derivatives. It was the other way around — the bankers were chasing, soliciting the unwary exporters to offer the derivatives.
Transferring risk?
Sixth, different banks that marketed their derivatives products to customers never made even basic inquiries as to the derivatives positions taken by the concerned customers with other banks.
Turning a blind eye to the derivative positions of an exporter with other banks, the derivative enthusiasts sold their wares to exporters just getting an undertaking — that he had no derivative position with other banks — on the form sent by the banks themselves by e-mail! Clearly, a false statement solicited by banks for record purposes to sell their derivative wares.
In some cases, the banks seem to have gone further and even did deals for the exporters without their knowledge, later using the signed letters in their possession to regularise the contracts! Undoubtedly, the law has been mercilessly broken in every conceivable way to structure and sell the derivatives to the under-prepared exporters. But why? Just for a fee? Unlikely. A larger motive seems to have been at work.
Having signed up risks in bulk as principals, did the banks recklessly market and retail their risk as market-makers to the unguarded exporters? There is more to it than meets the eye. Undoubtedly, a big scam in the making. Will the RBI wake up, probe, and get to the truth?
