A guide to foreign exchange for Indian businesses

If you are a business owner with customers outside India, understanding foreign exchange (forex or FX) is a necessity for efficiently managing international business payments.

The Indian rupee’s value against major global currencies like the US dollar can significantly impact your bottom line. In 2022, the Rupee depreciated by about 10% against the US dollar, a fluctuation that could mean the difference between profit and loss for your business.

In this guide, we’ll explore what foreign exchange is, what causes it to fluctuate, and how these fluctuations can affect your business. In addition, we’ll explore strategies to help you manage forex risks and optimize your financial operations.

Simply put, forex market is the global financial marketplace where one is allowed to trade currencies.

The exchange rate is the price at which one currency can be exchanged for another. For example, if the USD/INR exchange rate is 83, it means 1 USD is equivalent to 83 Indian rupees.

Keeping in mind the exchange rate is essential for you to manage the pricing of your goods or services, and the overall profitability of international transactions.

The forex market is the largest and most liquid financial market in the world. According to the Bank for International Settlements, the average daily trading volume in the global forex market hit $7.5 trillion in 2022.

For Indian businesses of all sizes, the most relevant currency trade is usually USD/INR. However, other currency pairs like EUR/INR (Euro to Indian Rupee) and GBP/INR (British Pound to Indian Rupee) may also be important depending on your business partners and target markets.

Exchange rates are not fixed and can change frequently due to various economic and political factors. A basic understanding of the factors can help you anticipate potential changes and make informed decisions. Here are the key reasons for forex rate fluctuations:

• Interest rates: When a country's central bank raises interest rates, it typically strengthens the currency as it attracts more foreign investment seeking higher returns. For example, if the Reserve Bank of India (RBI) increases interest rates, it could lead to a stronger Rupee.

• Inflation rates: Higher inflation usually leads to a weaker currency, as its purchasing power decreases. India's inflation rate, as measured by the Consumer Price Index (CPI), plays a crucial role in determining the Rupee's value.

• Economic performance: Strong economic indicators like GDP growth and low unemployment tend to strengthen a country's currency. For instance, India's GDP growth rate, which was 7.2% in the fiscal year 2022-23, can influence the rupee's strength.

• Political stability: Countries with stable political environments often have stronger currencies. Political events in India, such as elections or significant policy changes, can impact the rupee's value.

• Trade balance: A trade surplus (more exports than imports) can strengthen a currency, while a deficit may weaken it. India's trade balance, which has historically been in deficit, influences the rupee's value.

• Government debt: High levels of government debt can lead to currency depreciation. India's debt-to-GDP ratio, which stood at 83.4% in 2022, is a factor that forex traders consider.

• Global economic events: Major global events, such as the COVID-19 pandemic or international conflicts, can cause significant forex fluctuations.

Foreign exchange rate (FX) fluctuations can significantly impact your business when you’re engaged in international trade. These currency movements can affect various aspects of your operations, from pricing and profit margins to competitiveness and cash flow. Let’s explore these in more detail:

• Export competitiveness: A weaker rupee can make your goods and services more attractive to foreign buyers. For example, if you’re selling a product for INR 10,000, it would cost $133.33 at an exchange rate of 75 USD/INR. But, if the rupee weakens to 80 USD/INR, the same product would cost your customer $125, potentially making your product more attractive for them.

• Profit margins: Unexpected currency fluctuations can affect your profit if you’re not on top of things. This is especially common if there is a large time difference between raising the invoice and receiving the payment. For example: If you raised an invoice for $10,000 for services provided to a customer in the US. At the time of the invoice being raised the USD to INR conversion is 83, translating to INR 8.3 Lakhs in expected revenue. But, at the time of payment the USD to INR conversion drops to 80, and the final receivable amount is INR 8 Lakhs. Which leads to a INR 30,000 shortfall.

• Cash flow management: Currency volatility can significantly impact your working capital requirements. You might need to maintain larger cash reserves to manage potential exchange rate fluctuations, typing up capital that could be used for other purposes.

• Pricing strategy: Exchange rate fluctuations can complicate your pricing strategy for international markets. You may need to adjust prices periodically to maintain profitability and competitiveness. This can be especially challenging for long-term contracts or when dealing with price-sensitive customers.

• Financial reporting: Forex fluctuations can significantly impact financial statements, creating volatility in reported revenues and profits. This affects key financial ratios, complicates year-on-year comparisons, and can distort the perceived financial health of your business. Compliance with Indian Accounting Standard (Ind AS) 21 and FEMA regulations adds complexity, requiring careful tracking and reporting for forex transactions. These challenges can complicate your audit processes, impact tax reporting and make financial forecasting more difficult.

To mitigate the risks associated with forex fluctuations, you can consider these strategies:

• Use forward contracts: These allow you to lock in a future exchange rate, providing certainty for upcoming transactions. For example, if you know you'll receive $10,000 in three months, you can enter into a forward contract to lock in a predetermined rate, protecting you from potential rupee appreciation.

• Diversify currency exposure: If possible, conduct business in multiple currencies to spread your risk. For instance, if you're exporting to both the US and Europe, having revenue in both USD and EUR can provide some hedging.

• Monitor exchange rates: Stay informed about currency trends and economic factors affecting exchange rates. Tools like currency alerts can help you track significant movements in relevant currency exchange rates.

• Adjust pricing strategies: Build some flexibility into your pricing to account for potential currency fluctuations. This could include currency adjustment clauses in contracts or quoting prices in your home currency (INR) where possible.

• Seek expert advice: Consider consulting with forex experts or using specialized forex management services designed for SMEs. These professionals can provide tailored strategies based on your specific business needs and risk tolerance.

• Implement a forex policy: Develop a clear forex management policy for your business, outlining how you'll handle foreign currency transactions, what strategies you'll use, and who's responsible for monitoring and managing forex risk.

Understanding and managing forex risk is essential for Indian SMEs engaged in international trade. The volatility of exchange rates can significantly impact your business's profitability and operations. By staying informed about forex fundamentals, recognizing the factors that influence exchange rates, and implementing appropriate risk management strategies, you can protect your business from adverse currency movements and capitalize on favorable trends.

Remember, effective forex management is not about predicting currency movements, but about minimizing the impact of unpredictable fluctuations on your business. With the right approach, you can turn the challenge of forex management into an opportunity for more stable and predictable international business operations.