Kotak - Lupin, ONGC, India Rupee - On a Slippery Slope

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ONGC

India Rupee - On a Slippery Slope

Rising Rupee

The appreciating rupee is helping the government fight inflation. Prices of essential commodities are coming down gradually. But on the flip side, this surge in the value of the rupee has raised concerns over the profits of exporters, particularly textile, information technology and other labour-intensive industries. The rupee is currently overvalued by 11 per cent, up from 8.3 per cent a month ago, according to a JP Morgan index.


The Reserve Bank of India, which oversees the rupee-dollar exchange rate, is allowing the rupee to appreciate. It has the approval of the government because in a Cabinet note on prices, the finance ministry has said a combination of rupee appreciation along with tightening monetary policies would be the best solution for tackling inflation.

The rupee has been strengthening against the dollar over the last couple of months. It touched a nine-year high of 41.57/58 against the dollar a few days back. Although this seems to be a short-term view of the government, speculation is now rife that the rupee might be allowed to breach the 40 per dollar mark or even higher.

An appreciation of the currency helps increase the supply of goods and services domestically by making imports cheaper and exports expensive. This, in turn, helps to control inflation. A rising rupee has a dampening effect on exports since they become more expensive in dollar terms while imports become cheaper.

However, the negative impact on exports is immediate. India's Federation of Indian Export Organisations (FIEO) says the appreciation of the rupee has severely eroded the profitability of exporters. For IT exporters the rising rupee could mean a fall in operating margins and increased costs as they will receive less rupees for each dollar earned. According to Ambit Capital, each percentage rise in the rupee shaves off 30 to 40 basis points from an IT company's margins.

Those in textile business face stiff competition from our two neighbours Bangladesh and China. Bangladesh's exports to the US increased by six per cent while ours declined by 12 per cent, despite a much larger production capacity. Chinese exports rose by an even higher 23 per cent. With the rise in rupee India's textile will become more expensive than those manufactured by our counterparts. The Southern India Mills Association (SIMA) appealed to the Centre to immediately control the rupee appreciation against the US dollar to sustain the export growth of the Indian textile and clothing industry and have a level-playing field in the global market.

BPOs could be the worst hit as the margins earned by the foreign companies from outsourcing jobs to India are coming under pressure. The ITeS sector is less likely post higher growth rates as it has done in the past.

Even the India Inc. is divided whether the Reserve Bank should take steps to protect exporters from the appreciating rupee that will adversely affect their profits. While leading business chamber CII says the domestic industry would have to accept a strengthening rupee in the short term, FICCI, Assocham and exporters' body FIEO want RBI to intervene and check the sharp rise in the currency.

The argument of controlling inflation through a stronger exchange rate works in theory which states that imports increase the supply of goods, and cheaper imported goods help control the cost of the typical consumption basket. This works fine in a country like the US, where everything from coffee to footwear and clothing is imported. But look closely at India's import basket. The largest components comprising our import baskets are crude oil and electrical and non-electrical machinery, that is, capital goods. The latter does not have much impact on inflation but the former does. But these are de facto administered prices. Besides petrol prices can be tweaked without reference to the exchange rate, simply by reducing duties, or asking oil companies to hold prices and reimbursing them from the tax kitty. This fiscal response is independent of rupee-dollar relation.

The rise of the rupee against the dollar is without precedent, and seems to have been determined by volatile flows, not by macro-fundamentals. In the absence of hedging instruments like currency futures it seems pernicious to let the rupee rise abruptly, all in the name of inflation control. India has close to 12 million small and medium enterprises. They contribute around 6.7 per cent to the GDP and employ 30 million people, second to agriculture. They comprise 35 per cent of the total exports.

It is important to remember that in India exports create employment. One can expect that all those sectors that have been adversely affected due to this appreciation of rupee will withhold their expansion plans and capital investment. This would translate into less employment opportunities, badly impacting job seekers. So, at the end of the day the government might be able to tame inflation but will have unemployment and diminishing growth rate as its policy by-products. All these are bad signals for our economy, which is one of the fastest growing nations in the world now.

The march of the rupee

If you offer to exchange US dollars for Indian rupees, a person who is aware of market trends would probably decline the offer. The rupee is showing its mettle in the foreign exchange markets. It has appreciated to an eight-year high of Rs 42.90 against the dollar. Since January 2006 till date, it has appreciated by almost 4.8 per cent. During calendar year 2006, it went up more than 3 per cent.

Improving economic fundamentals and stronger growth prospects have led to a global interest in the Indian economy. Foreign money is pouring in to ride the economic boom and take advantage of the rising interest rates and stock and real estate prices.

The net FII inflow (debt and equity) since January 2006 was close to $10 billion. Non-Resident Indians also remitted home a considerable amount of dollars. The higher interest rates in the domestic market compelled companies to borrow in dollars in foreign markets (external commercial borrowings) to fund their expansions plans. Naturally, when the supply of dollars exceeded the demand, the rupee soared.

What implications does an appreciating rupee have on the economy and the common man?

Indian exports are denominated in dollars. If the rupee appreciates and the dollar depreciates (other currencies remaining stable), Indian exports will become expensive and uncompetitive, leading to lower volumes. The appreciating rupee could also adversely impact the employment generating software and outsourcing (BPOs and KPOs) sectors' income, which is also denominated in dollars.

Thankfully, the Indian economy is less export-dependent than some of its Asian peers, where falling exports slows growth and brings in higher unemployment. Exports constitute less than 20 per cent of India's GDP, yet they are an important part of the economy.

Higher imports may add to the trade deficit (imports minus exports), which is not always in the interest of the economy.

NRI deposits and remittances would fetch less rupees for their dollars if the rupee continues appreciating. With the trade deficit deteriorating sharply, these remittances have helped India remain in a surplus situation on the balance of payments.

FIIs usually get money in India in dollars to invest in stocks and other assets. A stronger rupee will mean that they get a lower amount to invest. A rising rupee will add to the dollar returns of FIIs that don't hedge the currency risk.In order to prevent a rapid appreciation of the rupee, the RBI buys dollars from banks and sells rupees, which enhances the liquidity in the banking system.

If this liquidity is not sterilised (absorbed) out of the banking system by the RBI, interest rates are likely to fall. These excess dollars usually find their way to the country's foreign exchange reserves. The RBI and the government incur costs on account of the sterilisation measures and maintenance of reserves.

Higher reserves can be helpful in the event of an external financial crisis, such as the foreign exchange crisis in India in 1991.

The long-term intrinsic value of a currency is a function of various other factors, such as interest rate differentials, trade equations, and so on. It should be kept in mind that the rupee has appreciated primarily on account of the excess dollars chasing the economic boom in India.

Any reversal of such flows due to a change in the global perception of India could put the rupee under pressure.

Citigroup - Biocon, India Economics - Monetary Policy, Monsoons, Asia Macro View - Rupee

Citigroup - India Economics - Monsoons

Citigroup - India Economics - Monetary Policy

Citigroup - Asia Macro - Rupee View

Citigroup - Biocon

Indian rupee: The fall and its impact...

2004 was a volatile year for the Indian rupee. While the elections and the subsequent elevation of the UPA government to the seat of power saw the rupee dip below 46 levels during the first half of the year, the sharp depreciation of the dollar against the euro and major Asian currencies led to the rupee appreciating to 43.50 levels during the second half of the year. The rupee once again touched a high of 43.28 on May 11, 2005 in tandem with other Asian currencies after the Chinese government took a small but significant step in appreciating the yuan. Since then, the rupee has considerably depreciated (by around 7%) and here we examine why.

High crude prices take their toll: One of the key factors that led to the depreciation of the rupee is the impact of the high crude prices on the merchandise account. In the period between May 2004 and September 2005, the average price of the Indian basket increased from around US$ 40 per barrel to around US$ 60 per barrel leading to the widening of the trade deficit (Source: RBI). Typically, in a trade deficit scenario, depreciation of the rupee makes sense as a weaker rupee will make exports more competitive thereby easing, to some extent, the pressure on the trade deficit. However, given the fact that the demand for crude oil is relatively inelastic, the value of the import bill rises leading to a vicious circle. However, what is interesting to note is that during the above-mentioned period, there was a rise in the value of the Indian currency, which was largely attributed to the surge in FII inflows. That said, since the start of 2006, while the trade account continues to be in the red, the rupee has depreciated leading to a correction in this anomaly.

The FII impact: The quantum of FII money in the Indian stockmarket has played a significant role in the movement of the exchange rate. In fact, as mentioned earlier, in the past couple of years, despite the trade deficit, the value of the Indian currency has been rising mainly due to the surge in FII inflow into the country. As can be evinced from the graphs, the value of the rupee between December 2004 and June 2005 was supported by large inflows on account of FIIs to the tune of US$ 6 bn (Source: SEBI). Pitted against this, in the period between January 2006 and August 2006, when the FII inflow of money into Indian equities was relatively at its lowest (US$ 3.8 bn), the rupee has also depreciated from 44 levels to 46.50 levels.

The reduced interest rate differential between the US Fed rates and the Indian interest rates could also be attributed to the fall in the FII inflows. To put things in perspective, while US Fed has hiked interest rates to 5.25% in 2006 from a low of 1% in June 2004, the extent of rise in the reverse repo rate in India has been much slower and currently stands at 6%.

To sum up...
Given the slowdown in FII inflows in the last few months and the trade deficit, we believe that the fall in the value of the rupee was inevitable. While this is a positive scenario for export oriented sectors such as software, pharma and textiles amongst others, a major drawback of the same is that it will increase the burden of servicing and repaying of foreign debt of companies that have raised dollar denominated debt. Also, oil companies are an exception, as India imports around 70% of the oil that it consumes (the only respite being a fall in the crude prices). That said, we believe that, in the long-term, the Indian rupee is likely to be weaker against the greenback. Therefore, in such a scenario, while it is not possible to completely eliminate forex risks, those companies that adopt prudent hedging strategies will have that extra edge over their peers.

Via Equitymaster