Sunday, 25 December 2011

Rupee fall jacks up India's arms purchase bill

Defence factories had budgeted Rs 20,000 crore in forex payout for foreign components in "made-in-India" systems like this corvette, INS Kadmatt, pictured at its launch in Kolkata in October. The rupee's fall has raised that by 20%


by Ajai Shukla
Business Standard, 25th Dec 11

The falling rupee and the defence ministry’s (MoD’s) tardiness could cost India an extra Rs 15,000 crore for its planned purchase of 126 medium multi-role combat aircraft (MMRCA). On 31st Oct 2010, three months after the Indian Air Force submitted its flight trial report to the MoD (i.e. roughly the time needed for evaluating the price bids; negotiating a final cost; and awarding the contract) the rupee reached its high-water mark of Rs 43.71 to the dollar. Had the MoD signed the MMRCA contract then, the anticipated bid price of $15 billion would have amounted to Rs 65,565 crore. An extra Rs 1,311 crore for the 2% cost of hedging the forex risk would have taken the tab to Rs 66,876 crore.

Today, at about Rs 53 to the dollar, that $15 billion bid translates into Rs 79,500 crore. The 2% cost of forex hedging is Rs 1,590 crore, taking the bill to Rs 81,090 crore, Rs 15,525 crore more than last October. The MoD is set to pay almost twice the Rs 42,000 crore that was budgeted for the MMRCA.

If the MoD does not hedge the forex risk, and the dollar hits Rs 58, the MMRCA cost would rise further to a mind-boggling Rs 87,000 crore.

This disastrous exposure to the rupee’s diminishing fortunes is the MoD’s own failure. In 2003 a committee, headed by Shashanka Bhide of the National Council of Applied Economic Research (NCAER), examined a proposal to hedge forex risk in defence contracts. The committee’s unequivocal recommendation --- that the forex component of defence contracts be invariably hedged against fluctuation --- remains ignored to this day.

The Bhide Committee found that the cost of hedging forex risk would increase the cost of a contract by 2%, but not doing so risked an Exchange Rate Variation (ERV) that averaged 4-5% over the duration of a defence contract. This ERV is naturally larger during strongly negative periods for the rupee, like the present.

An illustrative example is provided by the MoD’s forex outgo this year of about Rs 50,000 crore. Hedging forex risk could cost 3% today (a high premium due to the rupee’s volatility); while ERV losses seem very likely to exceed 5%. The extra 2% lost on a Rs 50,000 crore forex payout amounts to a whopping Rs 1,000 crores.

MoD’s forex outgo

The MoD’s capital budget (Rs 69,199 crore in 2011-12), which buys new arms and equipment, is not all disbursed in foreign exchange. Institute of Defence Studies and Analysis (IDSA) expert, G Balachandran, says that barely Rs 25,000 crore of that amount would be disbursed in foreign exchange; the rest would be paid in rupees to Indian vendors. The bulk of this goes to the 8 defence public sector undertakings (DPSUs) like Hindustan Aeronautics Ltd and Bharat Electricals Ltd; and the 41 factories of the Ordnance Factory Board (OFB).

But DPSUs and the OFB --- which incorporate many foreign components in the equipment that they build --- will disburse another Rs 20,000 crore to foreign vendors this year, says Balachandran. That would raise the forex outgo to Rs 45,000 crore.

Additionally, a portion of the revenue budget (which is Rs 95,216 crore this fiscal) would be paid out in foreign exchange. The revenue budget is earmarked for running expenses like pay and allowances; maintenance and spare parts; housing and storage; food and fuel; all the day-to-day running of the military. Of this, about Rs 5,000 crore worth of ammunition, and aircraft spares and engines, are purchased from abroad.

That takes the MoD’s budgeted forex spend to approximately Rs 50,000 crore this year. Going by the exchange rate of Rs 44.43 at the start of this fiscal, the budget catered for about $11.25 billion in overseas payments.

Lopsided spending boosts loss

Only a small percentage of this was paid out in the first six months of this fiscal year, when the rupee was relatively stable. MoD sources say that, by October-end (the latest figures available), just 37% of the capital budget had been expended, i.e. the equivalent of $4.15 billion, with procurement worth $7.1 billion still pending.

Skewing spending towards the end of the financial year, is standard MoD malpractice; in the last fiscal year, the MoD did 33% of its capital procurement in the last month, i.e. March 2011.

Since the dollar was relatively stable then the damage was limited. Over the last three months, the dollar’s sprint to Rs 53 levels means that the remaining outgo of $7.1 billion will cost Rs 37,630 crore, Rs 6,000 crore more than the budgeted amount.

In contrast to the under spent capital budget, the revenue budget is overspent: 62% of the revenue budget was spent by end-October, say sources. At this stage last fiscal, just 56% of the revenue budget had been spent.

With the Ministry of Finance (MoF) grappling with the national fiscal deficit, MoD officials do not realistically expect assistance from that quarter. By end-October the fiscal deficit was already 74.4% of the budgeted figure (compared to 42.6% last year). The MoF has issued a note requesting all ministries to prune expenditure.

“The writing is on the wall. It seems we will have to cross-subsidise our revenue budget from our capital budget this year”, says a senior MoD official.

9 comments:

Anonymous said...

I had a dream tat u posted FGFA report ....

Anonymous said...

Thanks for this article which again highlights the incompetence of few for which the entire country will now have to pay. :(

Anonymous said...

Sir,
Payment will not be a one time payment. It will be like EMI i.e. in batches. So saying that all $15 billion USD will be given right away is wrong assumption. So even if the decision was to be made earlier, we could not have made must savings. correct me if i am wrong

Mr. Ra said...

That is why it is generally said that the projects and agreements shall not be delayed unnecessarily. Now they have to suffer on many fronts on various accounts.

Anyhow we are behind and late in the race of the modern weapons, so our indigenous development of military equipment needs to be hastened with quantum jumps notwithstanding the financial stresses it creates.

Anonymous said...

Yet another reason to indigenise, indigenise, indigenise....


---Sharmishtha

rustom said...

What causes this fluctuations..With all the theories, its like the stock exchange where by it is acknowledged that it sometimes makes no logical sense. There are far too many market players to pull, adjust strings the right way.

The US being the largest creditor, yet the USD is well accepted and a currency for international payments.
The euro...with all theories, the UK has not joined in, and apart from a few countires contributing it positively, the bulks growth is wither negative or weak.Croatia has just joined in. Really no logical conclusion. It might just be that the euro which was formed to avert a ww2 like situation would just be the cause of it. Theories are falling apart.
I say all this to simply highlight the acknowledgement of backdoor players in defence deals and economies. It has always been so in History. Gen Tito added one more dimension, export of thugs and looking after them as long as they contributed back to their motherland in terms of money sent back. But thats is a bit offshoot of the topic here

Ever since the news of the deal being finalised, the ruppee has weakened...ever since the finalisatiuon within the fortnight has been added to the news, the rupee slide is ever more angled..

One wonders if there is a link to the deal to be signed and the ruppee value at that time....

Mr. Ra said...

USA and EU both are facing the severe economical crisis, but comparatively the businessmen have more confidence in dollar than Euro, so dollar is rising in comparison to Euro. Other currencies are getting adjusted as per their individual demands.

Rupee is falling consistently in comparison to both the dollar and Euro, so the import for India becomes costlier. At such occasions India shall refrain from the import of full equipment, but shall continue with the import of needed components with the hope that the dollar falls down a day.

Now I am afraid that MMRCA will be further delayed and J-20 will arrive earlier. Lol...

Anonymous said...

If you comment that there is no hedging by the MOD is correct than this is really irresponsible of them.

Every major company and multinational I have advised in my line of work hedges forex. This is a reality and best practice in todays borderless commercial world.

At worst, regs permitting, the MOD should have bought US dollars with the inital budgeted amounts when the Rupee climbed.

The MOD and GOI needs to get its creaking bureaucratic brains into the 21 century commercial best pratcice to prevent waste and risk after all they are merely trustees of the taxpayer money they are spending.

Thanks

PHL

Anonymous said...

Mr Shukla,

This entire article is a joke. I am a MBA in Finance and work at a major US Bank in structured deals for the last 8+ years. Deals of this scale and nature (6-8 years for total deal closure) have minimal exposure to the prevailing exchange rate. Payments will be spread out based on zillion factors. Rest assured, if the Ministry of Finance is worth its salt, India will NOT PAY A SINGLE DOLLAR for the next one year (probably more).

The GoI will issue a firm Letter of Intent/Procurement which will be used by Dassault/BAE to procure financing from multiple agencies.

I could go on and on on how the deal could be structured/payment terms and options etc etc. But as per the world of Finance and if there is a shrewd person in the Ministry of Finance handling this (or should i say a honest person), India need NOT pay a single dollar/Euro till the first Rafale/ EF rolls off the assembly line. If there is a person of average IQ, we will make a "goodwill" upfront payment. And if we are suckers like our past PM, we will pay Rs 1000 crores to the Ruskies to develop the SU-30MKI.

Note-My point is they can structure the deal to not pay a dime till the first aircraft rolls of the assembly line. But considering that corruption is part of the Indian DNA, I will not be surprised if our political leadership sells our country by entering into a hedge at prevailing exchange rate (which not even a rookie at our Bank will do-but then his DNA is not corrupted)