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