Gains from Falling Rupee

Benjamin Graham once compared value investing to smoking a discarded half-smoked cigar. While there would be only a few puffs left, the cigar was good value because it was free. By analogy, buying the beaten-down stock of a business in bad shape is a good bargain.

There are similar ways to look for possible opportunities in broadly adverse situations. One such situation is brewing in India's export sector. The macro-economic situation and in particular, the external balance of payments, is such that there's a very good chance the rupee will fall over the next year or two. This should in turn boost exports and that means a number of depressed industries may rebound.

This is no certainty. The rupee may go into a full-blown currency crisis. Or the global economy may go into recession again. But if the rupee weakens steadily without a crisis, it would be good for exports. This is a high-probability scenario, and it's worth trying to understand what could happen. (All numbers are rounded in what follows).

India has a trade deficit (the difference between goods exports and imports) of $190 billion. This is about 10 per cent of GDP. Exports stagnated in 2012-13, falling 1.8 per cent to around $300 billion. However exports in March 2013 saw a jump to $30-plus billion, a 13-month high that broke an 8-month falling trend. Services exports (IT mainly) and remittances will redress the balance somewhat and the Current Account Deficit is about $90 billion. The adverse trade balance creates some pressure on the rupee.

In 2013-14, there's hope that exports will pick up, maybe hitting the $330 billion mark. There's also hope imports will reduce. Crude, the single largest item on the import list, at $81 billion in 2012-13, has seen a marked drop in price. If crude stays down, imports will significantly reduce .

The second-largest import item is gold, at $24 billion. That has also seen a significant fall and it may now be in a long-term corrective phase. Again, this is good for the trade balance.

Nevertheless, even with lower crude and gold prices there will be a significantly negative trade balance even though it should be quite a lot lower. So the exchange rate pressure on these grounds will remain.

India has $290 billion in forex reserves. Of this, about $30 billion is bullion and IMF Special Drawing Rights. In effect, India has about $260 billion of hard currency reserves. That is six to seven months of import cover - comfortable enough. However, India's external debt obligations are at $376 billion. Of this, around $90-100 billion will need to be repaid within the next 12 months. That short-term debt will have to be financed and it's guaranteed to cause some drawdown.

Two key sources of forex inflows are FDI investments and FII investments. The good thing about FDI funding is that it is long-term and near-permanent if the concerned business does well. Unfortunately, FDI is also hedged with all sorts of restrictions and regulations and it takes a long while to fructify. FII funding, on the other hand, can enter and leave within a day.

FDI investments dropped to a 10-year low of $31 billion in 2012-13. FII investments (debt and equity combined) amounted to about $25 billion. Let's assume that 2013-14 inflows of FDI and FII combined will amount to somewhere between $55-60 billion. In that case, if other things remain stable, India will experience a drawdown of about $30-35 billion on reserves.

On the other hand, consider a more gloomy scenario. FII hold assets worth $145 billion in Indian equity and debt. If, instead of buying more Indian assets, they decide to reduce their exposure, there will be an outflow. That would lead to greater pressure on reserves and a larger drawdown.

The perfect storm would arise if everything went wrong. Let's say the trade balance ballooned with crude rising in price again, and ditto, gold. At the same time, exports stagnated. The FIIs sold heavily instead of buying. FDI inflows fell even further. Even then, reserves are sufficient to rise things out. In the worst case scenarios, India would still be left with $125-150 billion plus of currency reserves as well as its bullion.

But in that case, there could be a panic and a run on the rupee. As far as forex traders are concerned, signs of a liquidity crisis could tempt them into taking the hammer to the rupee. At what stage would traders start getting nervous? It could be if reserves fell below $250 billion, or below $225 billion, or below $200 billion. Nobody knows, including forex traders, what the tipping point for a panic situation would be.

But it seems unlikely to happen. The RBI has some control because, apart from possessing large reserves, the rupee isn't fully convertible. But the central bank also has to ensure that it doesn't fritter away reserves in fighting a losing battle. So it is more likely to intervene once in a while and stabilise the fall than try for day-to-day control.

The market is expecting some sort of a drawdown in reserves. So long as this occurs in stable orderly fashion, there will be no panic. Indian reserves have fallen from highs of around $325 billion in the past 3 years. The net effect on the rupee has been negative but there has been no panic since the fall has been controlled.

In mathematical terms, the market will stay sanguine so long as the rate of change in the exchange rate is predictable. If things proceed as expected, the rupee will probably slide to the lower end of the Rs 55-57 range versus the US dollar by 2013-14 end. It may even fall a bit further. If there is panic, the rupee could fall a lot further and it could happen in disorderly fashion with a pattern of sharp crashes and recoveries. That would be dangerous.

The other big factor that influences exchange rates is relative interest rates across currencies. The theoretical equation compares two interest rates over the same period. Suppose the rupee interest rate is say, 7 per cent per annum and the dollar interest rate is 2 per cent, and the current exchange rate is say, Rs 55 per USD.

The trader will assume that Rs 55x1.07 will be equal to $1.02 in a year's time and adjust expectations accordingly. This works really well with a hard currency because it is possible to arbitrage via "carry trades".

That is the trader can borrow in USD, convert to rupees, receive the rupee interest rate and convert back to USD, paying the USD interest rate. It is reasonably easy for an FII to do this as well, playing the Indian government treasury market. However, this is one-way; an Indian cannot carry out the reverse trade, borrowing in rupees and lending in USD because of capital controls. The market distortion caused by currency controls retards a potential rupee strengthening.

In nominal terms, rupee interest rates are way above every hard currency. However, this equation only holds true for real interest rates, net of inflation. It has to be adjusted for inflation expectations and hence, for expected interest rate changes.

This gets complicated. Indian rupee interest rates are positive with respect to the wholesale price index (currently WPI is at 6 per cent). But rupee rates are negative if one considers consumer price indices (CPI is over 10.3 per cent). The expectation is that the RBI will lower interest rates. It is very likely that rupee interest rates could go negative in real terms sometime in 2013-14. This could actually lead to some rupee hardening. It sounds counter-intuitive but it's possible despite currency controls.

Net-net however, one expects the rupee to decline because the external balance of payments is so markedly negative in every scenario. A declining rupee will make exports more competitive and it also gives exporters more profits in rupee terms provided the decline is orderly.

IT is the obvious focus industry where exports are concerned, But pharma, textiles, jewellery, machinery and instruments, automobiles and auto-ancillaries, steel, etc., are also very much part of the export basket. Each of these industries has specific markets and specific issues to contend with. Their gains from a falling rupee will be uneven. But there should be gains.

This article was originally published on May 03, 2013.