In economics, as in everything else, small, micro and ‘seemingly insignificant’ developments usually hold much larger lessons and systemic implications. The important task is to understand the larger message from those micro developments for the purpose of policy making, or rather for reforming policy.

For example, it may be a truism to say that the economics at the level of a firm, company or industry is just a reflection of the larger macro economic policy environment. And, where the larger macro economic environment is buffeted by volatility and uncertainty, the economic and financial performance of an individual firm or industry, for sure, would be affected. What is the remedy for the individual firm or industry’s troubles in this scenario? Is it treating the symptoms and providing a temporary palliative or is it going for structural, long-term solutions and attacking the underlying causes of the problem? In other words, do we understand the larger message and go in for macro economic policy changes or do we just gloss over the larger implications and go in for temporary, micro economic solutions?

To be sure, the stress on macro economic structural solutions does not lessen the need for or importance of individual firms / industry taking such ameliorative or risk management measures as may be required. The argument here really is whether national policy makers should go in for ad hoc measures instead of attacking the root causes of a problem.

AS 11 amendment - A temporary solution
That toss up between short-term and long term policy responses is a question which has long confronted policy makers across countries. That is the question which confronted Indian policy makers also in recent months with respect to the application of Accounting Standard (AS) 11 in drawing up the financial statements of companies for year ended March 2009.
AS 11 sets the standard for the accounting treatment to be followed to reflect the impact of changed exchange rates when drawing up a company’s financial statements. For instance, a company may have borrowed $ 100 million when the rupee quoted at 40 against the dollar. At a subsequent date, when the company has to draw up its financial statements and if the rupee has, in the mean time, fallen against the dollar to, say, 45, there is a (notional) loss of Rs.50 crore on account of the change in the exchange rates. AS 11, till recently, prescribed that such a loss of Rs.50 crore would have to be reflected in the company’s earnings statements and in the balance sheet to give a true and fair view of the company’s financial position. As can be noted, this was just the application of the principle of mark-to-market or fair value accounting with respect to capital items ie financial liabilities and assets. It is also important to note that some of the notional losses could get crystallised into actual losses if the foreign currency liabilities were being amortised. It was, therefore, all the more imperative from a fair value perspective, to reflect the impact of changed exchange rates in financial statements.

This stand(ard) of the accounting regulators came under severe strain recently. Reason: the steep value loss in the Indian rupee’s exchange rate in the second half of 2008 threatened to splash a large amount of red on many companies’ earnings statements and balance sheets. Scores of companies which had contracted large amounts of foreign currency borrowings in the immediately preceding period -when the rupee’s trend was stable to appreciating - now faced the prospect of accounting for this (notional) loss in their financial statements. Bharti Airtel, Tata Motors, Tata Steel, JSW Steel, Punj Lloyd, Mahindra & Mahindra, to name just a few, the list comprises some of the most prominent names in the Indian corporate sector with (notional) losses running into hundreds of crores of rupees.

Under intense pressure from the affected companies and generally from the corporate sector, the Ministry of Corporate Affairs - in a literally eleventh hour move, on 31 March, 2009 amended AS 11 to provide that such valuation losses could be capitalized and need not be shown (as a negative item) on companies’ revenue statements. The asset and liability values on the balance sheet would be inflated leaving the profit statement untouched.

Structural FX policy issue remains unaddressed

The amendment of AS 11 may provide, at best, only transient relief to affected companies. With the knock on effect of the economic slowdown already having an adverse impact on profitability, companies sure would welcome even such transient relief. But looking beyond the short-term, it would serve all stakeholders interests well if this episode also were to contribute to kindling a re-think and re-formulation of the country’s exchange rate policy.

Indeed, that is the larger and structural macro economic policy and the ambiguities about that policy that this micro economic episode has sharply highlighted. (Surprisingly, this structural issue has not garnered much attention (if any at all) in all the debates in the print / electronic media and in the lecture circuit about the amendments to AS 11). And if the route which has been taken now - that of amending the accounting standards to tide over volatile macro economic conditions - is any indication, policy makers do not seem to be addressing the structural issue at all.

The structural problem relates to the inconsistency in the country’s exchange rate policy. It is this inconsistency that has landed much of the Indian corporate sector now in this difficult situation - where they have to go to the extent of amending some accounting standards / principles and avoid disclosure of losses.

The exchange rate policy that has been articulated by official bodies says that India will adopt a mix of the following policy stances with respect to exchange rate management.

When capital inflows are very strong (the scenario which is relevant for the present case) the official policy stance will be a ‘judicious combination’ of the following:
● Allow some appreciation in the rupee
● Liberalize outflows of foreign exchange through both the current and capital accounts
● Intervene to buy up excess dollars and sterilize the rupee liquidity impact of the intervention.
In the reverse direction, when capital inflows are net negative and have dried up and when the rupee is under downward pressure, the same ‘judicious combination’ policy stance should mean the following:
● Some depreciation in the rupee
● Restrictions on outflows and encouragement of inflows
● Intervention to sell dollars in the market

High level of ambiguity

This policy framework imparts a high degree of ambiguity and uncertainty about the overall exchange rate environment. For instance, how are market participants to know when the policy maker will allow appreciation, when outflows will be liberalized and when he will intervene and sterilize the impact of his intervention. Timing uncertainty is very high here as there is complete discretion for the policy maker to employ his strategies in whatever manner (and proportion) he deems appropriate.
Moreover, as has been painfully observed in the recent instance of rupee depreciation, the same ‘judicious combination’ does not seem to operate when there are capital outflows and the rupee is under pressure to fall. Officially, there seems a bias in favour of preventing or at least slowing rupee appreciation whereas rupee depreciation is not that forcefully (if at all) prevented or minimized.

Now, think of the financing strategy of an Indian corporate who goes in for foreign currency borrowings on the expectation of (i) structural appreciation in the rupee and (ii) the ‘judicious policy combination’ being employed. This is what has been done by scores of Indian companies in the past 2 or 3 years.

Even if that expectation proves wrong because of other overwhelming systemic developments (as has happened consequent to the global financial crisis), would the corporate be right in thinking (hoping) that, based on official exchange rate policy in the past (the combination referred to above), Indian policy makers would prevent too heavy a fall in the rupee?
Well, if Indian corporates embarked on FX borrowings based on such hopes, they have been clearly belied by recent developments. That, in turn, has compelled the tinkering with the accounting standards. There cannot be a stronger signal for a total re-assessment of our FX policy.