foreign exchange risk management | investment | insurance | strategy
The government plans to create a forex hedge fund, again. What does it even mean?
The idea dates back to a few years ago, mainly to attract foreign investors
In the investment world, hedging is the practice of reducing investment risk. It ensures that if one investment incurs potential loss, then there is another investment that helps offset the loss. Hedging is a bit like insurance (but not as secure as insurance), and comes with an initial cost and in some cases–higher risk. Though there are plenty of hedging strategies available to investors, no strategy can eliminate the risk completely.
The idea behind “forex hedge funds” comes from volatility in foreign-exchange rates. Foreign-exchange (forex) markets see lots of fluctuations in exchange rates, because of the high volume of trading and forex being a speculative activity for many. So a forex hedge fund helps ensure protection from potential losses for investors against fluctuations in forex markets. The fund compensates the losses partially or totally.
Foreign investment entails plenty of risks. It could be political risk, exchange-rate or sovereign risk. The most unsettling is the risk that comes with exchange-rate volatility. How?
Changes in the value of currencies can have both positive and negative impacts on foreign investments. Sometimes investors may benefit from it, but not all the time. Hence risky.
For example, an investor abroad wishing to invest in a foreign country must first convert their domestic currency (say US dollars) to a foreign currency to invest. Then later convert that foreign currency back to the US dollars. At the time of exchange, if the value of US dollars has strengthened against the foreign currency, then the rate of return on that investment will be less than initially expected. The reverse is also true. In case of weak US dollars, the investor will benefit.
It is for this reason, the government wants to attract foreign investors, wary of investing in Nepal due to exchange-rate risk, through creating a forex hedge fund at the central bank. The fund will pave the way for investors eyeing to invest in infrastructure projects, like hydropower. This is not a new thing for the country, however.
The momentum for setting up a fund dates back to a few years ago. In 2017 draft regulation for operating the fund was approved after Rasuwa-Bhotekoshi and Upper Trishuli-1 signed power purchase agreements in the US dollars with the Nepal Electricity Authority (NEA). What this means is that the NEA signed an agreement to buy power generated by those plants in dollars for a period of 10 years, or until foreign loans were paid by the developers of the projects.
But paying in the dollars was a risky agreement. So NEA and the developers agreed to create a hedge fund in order to reduce exchange-rate risk, with both parties and the government contributing to the fund (like a premium). The fund would cover losses created to any party in case of weaker domestic currency against the dollars.
Yet disagreements over how much each party should contribute to the fund still continue, derailing many hydropower projects backed by foreign loans. In 2019 a row over individual contribution to the fund led NWEDC, an energy utility company, to nearly halt the development of the 216 MW Upper Trishuli-1 Hydropower project. The utility company was asked to chip in half of the fund amount–that is, $150 million. But the developer showed interest in contributing just $5 million, reported the Kathmandu Post.
A properly functioning hedge fund to subdue volatility risk–for investors–arising from forex markets has not been created yet. Until clear policies on risk-sharing among stakeholders come into effect, setting up forex hedge funds will take time.
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