Rupee Impact

It’s yet another earnings season and the appreciating rupee seems to have cast its long shadow over many companies—especially those that are heavily dependent on export revenues.

But how serious could the problem be in the long term? The general reaction seems to be uniformly pessimistic. Equity analysts have been busy cutting profit projections for software and pharmaceutical firms, and the early quarterly results show definite cause for concern. Business lobbies have sent dark warnings to the government about how small garment and textile exporters are headed for deep trouble. And the government is in the process of providing some fiscal sops to exporters hit by the rising rupee. Meanwhile, to provide a more optimistic view, economists are wondering whether a strong currency will actually bring down domestic inflation.

There is a common thread in these expectations—the assumption that a strong rupee will have a deflationary impact on Indian companies. Export revenues (and hence total revenues) in terms of rupees will be lower than expected. And cheaper imports will restrict the ability of companies to raise the prices of the stuff they sell. In other words, a strong rupee will hinder growth and help curb inflation.

These assumptions are well within the traditional debates on the impact of currency movements on the real economy of output and prices. But, are there other possibilities? By focusing exclusively on the deflationary effects, the current debate has ignored the other possibility—that a strong currency can, in certain cases, dramatically help certain companies (though with a lot of attendant risks).

The trick is to look not just at the revenue statements of companies, but also at their balance sheets. Many large companies that have borrowed money abroad in recent years are likely to benefit from the strong rupee. The value of their foreign debt in rupee terms will drop because of a sustained rise in the value of the Indian currency, helping lower capital costs.

Indian balance sheets have become increasingly globalized over this decade, as rising foreign exchange reserves have emboldened the government and the Reserve Bank of India (RBI) to allow domestic companies to borrow and buy abroad. A lot of fawning attention has been paid to this globalization on the asset side. International acquisitions make for good headlines and feed nationalist pride.

But an equally dramatic dose of globalization is evident on the liabilities side, too. Indian companies have borrowed billions of dollars over the past few years, through external commercial borrowings and convertible bonds. Much of this has been contracted in dollars—and has to be repaid in that currency. The value of this debt in rupee terms will drop as the Indian currency appreciates—companies will need fewer rupees to repay it.

This means the rise of the rupee will lead to significant savings for companies that have piles of foreign debt in their balance sheets. But rather perversely, it is the companies that have been on a global borrowing binge that will gain in comparison to those that have little debt on their books. Financial adventurism will pay more than financial prudence—at least till the next global financial earthquake shakes the adventurers out of their comfort.
Yet, till then, it would be interesting to see whether gains on the balance sheets of Indian companies more than cancel out the losses that will pop up in the revenue statements. Only then will we know for sure whether the negative effects of a strong rupee are as serious as currently assumed.

Does this seem far-fetched?

Look at what happened in East Asia in 1997 to see a mirror image of today’s dilemmas in India. Stable currencies and premature capital account convertibility in the early 1990s acted as an incentive for companies in the region to rush abroad to borrow at low interest rates. This cheap money was used to finance domestic investments. By the middle of 1997, many of the biggest companies in the region had warped balance sheets—with assets in local currencies being funded with dollar liabilities. They were sitting ducks in the event of a currency crisis.

And that’s precisely what happened. The sudden and sharp drop in regional currencies 10 years ago tore these balance sheets to tatters. The devaluation of Asian currencies thus led to an investment crunch and worsened the macroeconomic crisis. In other words, Asia in 1997 is almost a mirror image of India in 2007. The question is: Will currency appreciation have positive balance sheet effects just as currency depreciations had negative effects 10 years ago?

In other words, the situation is far more complicated than commonly assumed. It will be interesting to see how currency appreciation works itself through corporate revenues and balance sheets in India in the quarters ahead. In fact, a further rise in the rupee could pay large Indian companies a huge dividend at the cost of global banks and bond investors.