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The Chartist: Rising Rupee

Rising rupee is not a bad thing. Crude import burden has eased. It will help Tata Steel, Hindalco etc to buy companies cheap abroad

Be careful what you wish for, it may come true”, is an old Russian proverb from illustrated fairy-tales. We are seeing a real-life illustration in forex markets. For decades, Indians wished for a strong rupee. We toured abroad on $1 a day. We bought smuggled goods because all imports were illegal. It was a criminal offence to invest abroad.

The BOP crisis of 1991 led to changed policies. But it took years before ground reality changed. FDI came in, portfolio investments came in and exports soared. The rupee depreciated. By and large, depreciation was gradual. After the first shock depreciation of Rs 17 to 29 per USD in mid 1991, it gradually dropped to Rs 47 in 2006. That is a CAGR of roughly 4 per cent between 1992 and 2006.

While the rupee weakened, three trends became clear though of course, you could argue about the underlying reasons. One, Indian business became globally competitive. Two, that led to portfolio inflows. Three, India's massive domestic market and value-for-money skill-sets led to continuous FDI inflows.

In the past year, the rupee's direction has changed. It's hitting 9-year highs against its main trade partner's currency, the USD. The inflows have continued. Since February 2007, the Defty and Dollex indices have positive returns (7.5-8 per cent ) due to currency appreciation, though the rupee counterparts have negative returns (Nifty/ Sensex down 3.5-4 per cent). A momentum hedge-trader with the currency edge has reason to continue pouring money into rupee assets. Crude imports would have been more of a burden but for the 8 per cent rupee rise of the past 12 months. The retail sector would have been hit hard by inflation that led to reduced demand except for cheap foreign goods that have denied unlimited pricing power to domestic manufacturers.

Apart from crude, India's key imports include infrastructure equipment and other capital goods. This will add up to a huge amount ($300 billion-plus) over the next five years. So, a strong rupee is not a bad thing. It also makes it possible for Tata Steel, Hindalco and other corporates seeking overseas acquisitions to finance cheaper.

But a strong rupee hits exporters. About 70 per cent of India's trade (including invisibles) is dollar-denominated. USD-denominated exporters hurt both ways ­their services and goods become more expensive and they earn less in home currency. If exports slide, India will see the trade balance shift further into the red before the rupee corrects down again.

The RBI has to find solutions to an insoluble problem called the "impossible trinity". Monetary policy, forex rates and free capital flows: if you wish to control the first two, you cannot allow the third. In fact, if you want any two, you cannot control the third.

The RBI must allow free capital flows whether it wants to or not because India needs the capital to fund GDP growth. It has even raised the limit on individuals in overseas investments up to $100,000 per capita. If free capital outflows are not allowed, the tap on inflows will be switched off. It must also control money supply to combat politically-sensitive inflation. And, ideally, it has to manage a gentle depreciation.

Thus far, this is just economic theorising. In political terms, forex rates are the lowest priority in this triad. I think the RBI will be forced to keep money supply tight and interest rates high. It cannot choke capital outflows through fiat without jeopardising inflows. So, it cannot discourage investment abroad.

Hence, it will let go the leash on forex rates. A long-term Indian investor can shrug and diversify abroad, ignoring near-time rate fluctuations. You may get the best of both worlds; invest substantially when overseas assets are relatively cheap. And, when the rupee weakens, book positive returns on the currency move. Look out for NFOs, which help you to invest in USD-denominated assets.

Among domestic stocks, I see two sectors, which must benefit. One is telecom, where massive capital equipment imports and investment inflows will come at better bang for the buck.

The other is the IT/ ITES majors in the long run. Don't forget, the rupee has depreciated against the Euro and the Pound Sterling. Infosys garners 27 per cent of its revenues in those currencies, TCS generates 28 per cent and Wipro around 25 per cent. What's more, non-US revenues are growing quicker than dollar revenues. This will be accentuated by currency trends. It should energise IT majors to deliver positive surprises in terms of non-dollar revenue growth over the next 4-6 quarters. Again, you have a chance to buy cheap now.