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The Chartist: Forex Risks

Currency trends are influenced by underlying macro-economic variables such as external debts, trade balances, fiscal deficits, interest rate differentials, money supply, etc.

Currency trends are influenced by underlying macro-economic variables such as external debts, trade balances, fiscal deficits, interest rate differentials, money supply, etc. Central banks build models with thousands of differential equations to work out the exact details. It's necessary because central banks have to set policy interest rates, control money supply and balance off inflation versus GDP growth.

Forex traders don't set interest rates or control money supply. They only need to make a call on direction of currency trends. So, traders often use a rough calculation called a covered interest arbitrage. Here's an example, with the indicative rates of July 26, 2006.

Suppose you hold $1. The risk-free dollar interest rate is 5.3 per cent (US 1-year US T-Bill yields). The current rupee-dollar rate is Rs 46.76/$. The 12-month forward premium is 1.12 per cent so, the rupee-dollar forward rate is about Rs 47.28/$. The risk-free rupee yield on the 364-day T-Bill is between 6.95 per cent and 7.07 per cent.

There are two sets of transactions that are equally easy and risk-free. Hence if the rates are stable, these transactions should fetch roughly equal amounts.

A) The dollar can be parked in US T-Bills and converted to rupees after 12-months. It yields $1.053. That sum locked in at the forward rate of Rs 47.28 yields about Rs 49.8.

B) The dollar can be converted at current rates, for Rs 46.76. This is parked in Indian T-Bills at 6.95-7.07 per cent and locked-in at the forward rate of Rs 47.28. The re-conversion yields between Rs 50.01 and Rs 50.07. Or, $1.057-$1.059 in dollar terms.

Note that these amounts are not equal. That implies a fairly significant correction since these transactions are often actually carried out for huge sums.

This rough calculation will always be subject to error. Even with two fully-convertible currencies, forex rates fluctuate continuously as do interest rates. A small differential can be written off to slippages. In the case of the rupee, the slippages are larger because you cannot walk into a bank and buy dollars off the counter with rupees.

But a difference of over 0.5 per cent in dollar yields is much too large to be written off. Thus, there will be a correction. There are several ways in which corrections could lead to a new equilibrium. (All these variables change continuously and simultaneously. But let's assume for the sake of simplicity that a major change in one variable leads to changes in others.)

One possibility: dollar interest rates will rise by about 0.5 per cent pulling up “pure” dollar returns. If we refer to the US Federal Reserve's policy since 2004, this is likely. The Fed has continuously raised policy rates and there has been a convergence between rupee and dollar interest rates as a result. But the Fed chairman has issued statements recently that suggest the rate hikes will ease off.

Another possibility is that the rupee will be stronger than expected over the next year. If say, the rupee trades at Rs 47/$ a year down the line, rather than the given forward rate of Rs 47.28, the equations will balance.

But this doesn't seem likely because of pressure on the rupee. India's trade balance (merchandise exports) and current account balance (merchandise plus invisibles such as goods, services and remittances) are in deficit and the deficit is growing.

According to the Reserve Bank of India's July 25 credit policy, the merchandise deficit is about $51 billion and the current account deficit is about $10.6 billion. The deficit is likely to grow through 2006-07 because of high oil prices. That will pull the rupee down.

Another possibility is that India's interest rates will come down. This is also very unlikely. The RBI has just hiked an important policy rate (the reverse-repo rate) and there is complete consensus that this will translate into higher rupee interest rates.

The rupee is very likely to see further depreciation against hard currencies. Since January 2006, the rupee has depreciated 4.7 per cent against the US dollar, by 8.4 per cent against the euro, by 10.2 per cent against the pound sterling and by 5.1 per cent against the yen during 2006-07 (up to July 21, 2006 according to RBI statistics). So, it's quite reasonable to expect this trend to translate into faster depreciation than implied by the current forwards.

That leads us to the last possibility. If the pure dollar return of $1.053 equals Rs 50.06 in July 2007, the rupee-dollar rate would need to be about Rs 47.54 a year down the line. The rupee will depreciate faster than implied currently.

If forex traders believe in this chain of logic, they will speculate and buy forward dollars (and other hard currencies) at current rates. If that becomes the fashion, it will become a self-fulfilling trend since it will create dollar demand and drive down the rupee.

What are the implications for the stockmarket? Any company with net forex exposure (either due to imports or due to raising debt abroad) will have higher payouts and greater risks. At the same time, anybody with net forex inflow will gain in rupee terms.

What sort of companies have net forex exposures? The most obvious ones are the PSU oil importers, which are in terrible shape for several other reasons.

Importers of capital equipment such as machinery are also exposed to forex risks. This puts a little question mark on the high-growth infrastructure sector, which is quite dependent on imports. As to foreign debt, that's scattered across the universe of Indian companies.

Major forex earners include shipping companies, information technology and IT-enabled services companies, pharma companies and textile manufacturers.

When we look at other parameters, IT is definitely the best choice among these sectors. IT companies are generally zero-debt, and the industry has higher growth rates than the other forex-earners.