DSIJ Mindshare

The story of a tumbling Rupee

Believe it or not, everyone gets their due share of the lime-light sometime or the other, and that opportunity is more than enough to bask in the attention that one gets. Something similar seems to have happened with the Rupee, whose brisk depreciation has been in the limelight recently, in the midst of the already-brewing concerns in the US and Europe. The baffling part is that it has come at a time when the US is in its worst shape, with an anticipated double-dip recession, while India, even with an estimated FY12 GDP of close to eight per cent, is still looking bet-ter. Besides trying to make sense of whether it is good news or bad news in the first place, dumbfounded market participants are clueless as to how to react to this sudden development.

While a quarter ago, nobody could have thought that the rupee could ever depreciate so quickly, some are already prophesying doomsday theories of the rupee further weakening against the dollar. Others are busy trying to draw parallels to a similarly brisk depreciation seen in the second half of 2008. While it is easy to point out what has happened, not many have been able to put a finger on WHY it has happened – which is a very important question that needs to be answered. We, at Dalal Street Investment Journal, have gone beyond this development and have not only understood the real reasons behind this slide, but also have gauged the levels we could probably see the rupee at by March 2012. What adds strength to our conviction is the interactions that we have had with the many market experts on the subject. Two such interactions are included towards the end of the story, in order to help our readers understand the rupee depreciation conundrum better.

While it is easy to say that it is the dollar that is strengthening against other currencies, including the rupee, our research shows that actually, a mix of domestic and international factors is currently affecting the Indian rupee. These factors are enumerated further.

Key Factors
There has been a general shortage of the dollar in the domestic markets, as FII and FDI inflows have slowed considerably. To make matters worse, there is a risk aversion amongst investors, who are seen flocking back to the dollar. Barring the New Zealand and Colombo stock markets, which were up by one per cent and two per cent respectively, all the other stock markets are in the red on a Year-to-Date basis, with Europe being beaten down badly. Leave aside Europe, sentiments have been dented to such an extent, that investors are staying away even from emerging markets such as India.

The situation is so bad, that on a Year-to-Date basis, FII inflows (including debts) to India stand at a mere USD 4.25 billion, out of which only USD 96.42 million has flown into equity. In fact, since the beginning of August 2011, when the markets turned shaky, FIIs have turned net sellers with a massive USD 1.76 billion of net sales in the month of August itself. Net outflows in September 2011 stood at USD 342.38 million. FDI flows were no different. Between January and April 2011, the overall FDI inflows stood at Rs 29189 crore, down by about 10 per cent over the same period last year. In fact, over the last three fiscals, FDI has declined from USD 37.8 billion in FY09 to USD 39.38 billion in FY11. FIIs are said to be one of the most potent forces that determine the direction of our equity market. In addition to the equity market, FIIs also play an important role in determining the exchange rate movement of the Indian rupee. There exists a positive correlation between FII flows and the value of the rupee. What this means is, when there is a net inflow from FIIs, the rupee strengthens or appreciates against the US dollar, and when there is a net outflow, it depreciates.[PAGE BREAK]
For example, in CY10, when we saw record FII inflows, the rupee appreciated by four per cent in the same time. Similarly, in CY08 when we experienced large FII outflows, the rupee tumbled by a massive 22 per cent. To give this a more mathematical colour, if the data of FII flows and movement in exchange rates for the last 11 years is regressed, we find that one-fifth of the rupee movement against the US dollar is explained by the FII flows. The situation, according to us, is not likely to reverse anytime soon. The reason for this is that investors are becoming risk averse once again, shunning emerging market equities as an asset class, and flocking to the US dollar.

Hence, in the near term, it looks like the USD will continue to remain strong as compared to the Indian rupee. In fact, the dollar as a currency is catching the fancy of investors, who are looking more at capital protection than anything else. While this may surprise many, it should be noted that while the US is itself in a mess, the situation in Europe is messier still. This, coupled with the fact that commodity markets are crumbling steadily as well, means that there is no better refuge for investors than the safety of the dollar, which has been the strongest currency available. “As far as the US and Europe are concerned, I think Europe is in a much worse shape as compared to the US, because it has fundamentally become weak, and I think it will remain weak for another decade or so”, says Dharmakirti Joshi, Chief Economist, CRISIL. A some-what similar sentiment is also shared by Indranil Pan, Chief Economist, Kotak Mahindra Bank. “Even though the ratings downgrade happened in the US, it will ultimately be an issue of relative risk, and obviously Europe was looking at a much greater risk than anybody else, which necessarily meant that we were looking at a general picture of a dollar appreciation” he says.

The other factor that created a further pressure on the rupee was the deferment of the ONGC FPO. The company was expected to raise around USD 2.5 billion from the market. In fact, there was lot of hype surrounding this high profile FPO, with the market anticipating huge dollar flows in the country. Past experience of the Coal India IPO gives us some sense of FII inflows that we could have expected, had the ONGC FPO sailed through. Coal India attracted more than USD 2 billion of FII inflows. Though the current situation is quite different, we would have definitely got some respite.  However, these hopes were dashed after the government postponed the FPO, citing weak market conditions and the subsidy burden. Nervousness crept in, leading to further pressure on the rupee, which depreciated sharply, and is down by 2.7 per cent from the date of deferment. In the month of August itself, the rupee depreciated by more than four per cent.

Many also perceived the recently cleared Iran crude oil payment worth USD 5 billion dollars, which was delayed after the RBI declined to facilitate payments through the existing mechanism, as one of the factors for rupee depreciation. India has an annual oil trade estimated at USD 12 billion with Iran. However, this deadlock broke just a month ago, after funds were arranged and routed through a Turkish bank and paid in full. However, what many don’t know is that India made the payment to the Turkish bank in euros, not in dollars. Thus, despite the fact that the payment was worth USD 5 billion dollars, India actually paid in euros. Hence this transaction would not have had any impact on the rupee-dollar levels.[PAGE BREAK]

Depreciating Rupee: 2011 Not Quite 2008
It is obvious that parallels would be drawn between the sharp rupee deprecation seen in the second half of 2008 and that happening now. However, we believe that the scenarios in which this happened have been different. Though both may show some similarity, they really aren’t comparable. In the first half of 2008, the rupee was trading at around Rs 39-40 to a dollar, but suddenly depreciated to touch Rs 50-levels by December 2008, a sharp fall within just three months.

Now, this looks fairly similar to the brisk slide seen in 2011, when the rupee was trading at Rs 44.62 levels at the beginning of August 2011, and depreciated by about 11 per cent to touch a high of Rs 49.67 towards the fag end of September 2011. A further exploration of these scenarios shows that one factor was common to both of them – the risk aversion in both these years, though it happened for different reasons. “There can be no parallels that could be drawn from the two scenarios of 2008 and 2011. Both ultimately culminated in risk aversion, but the reason why the rupee depreciation started in the first round was oil, and the rupee depreciation in the second round now is mainly due to risk aversion”, opines Pan.

In 2008, the risk aversion was more an outcome of the Subprime crisis, which was followed by the consequent credit freeze, global recession and terribly high crude prices, among other reasons. This time, the slide has more to do with the weak FII and FDI inflows, deferment of the ONGC FPO, rising demands for the dollar by India Inc., recessionary trends in the US and Europe and the anticipated fear of a future credit freeze.

Good News? We Don’t Think So!
While, in general, the depreciating rupee is good news for export-oriented companies, we don’t believe it would be a major positive this time around. First and foremost, it should be noted that export-oriented companies usually hedge their forex exposure to mitigate the risk of appreciation in the rupee. Thus, even if the rupee has depreciated by about nine per cent in the last three months or by 11 per cent in the last one month itself, due to the pace at which it has happened, these companies may not be able to enjoy the full benefits of the same. TCS, India’s largest exporter, too has voiced this concern. S Mahalingam, CFO and Executive Director, TCS, has this to say, “I can only talk about TCS. We hedge, and therefore, we may not participate fully in the depreciation.” As for the rupee levels in the next six months, he says, “We find it difficult to predict exchange values”.

The other concern we see is the imminent slowdown in demand in the US and the European region. If the scenario in the US and the European region does not improve (the probability of an improvement looks bleak, at least for now), the overall demand is bound to dip sharply, affecting the forex earnings of these export-oriented companies. Thus, even if the rupee stays weak against the dollar, it is highly impossible to expect the final revenue numbers to be any good.

While this is bad, the worst is right ahead, as the depreciating rupee will bloat the import bill. Crude oil imports themselves account for almost one-third of the total import bill, and considering that it is an essential commodity and has to be imported come what may, it will exert further down-ward pressure on the rupee.[PAGE BREAK]
While, at one end, the forex earnings are expected to stay stunted, the import bill is only expected to swell on account of a weak rupee, which will further increase the current account deficit. As of FY11, the total imports stood at USD 36 billion (USD 29.99 billion), while total exports stood at USD 23.8 billion during the same period. To make matters worse, it would also negate the benefits of the currently-falling commodity prices globally, and in turn lower inflation, as we would continue to pay more on a weak rupee. This can be exemplified by the fact that since the start of August 2011, crude has taken a beating of eight per cent, and in the same time the rupee has depreciated by a little more than ten per cent, negating all the benefits of the fall in crude oil prices. Therefore, the quantum of fall in the commodity prices should be large enough to cover the depreciation in the rupee, for any benefit to come out of it.

Factors Affecting The Way Ahead
Repayment Of Short-Term Debt – As for the way ahead, there are a few factors worth noting that could have a significant impact on the rupee movement in the coming months. The repayment of short-term debt in FY12 will put further pressure on the rupee. The total short-term and long-term debt maturing within one year and due for payment stands at USD 84.1 billion.

Now, this has increased by a massive 30 per cent over FY10, which is quite huge, and indicates a few things. This includes increased reliance of Indian corporates on foreign borrowings, the share of short-term debt increasing steadily, (currently standing at almost 28 per cent of total debts) and last, but not the least, recurring repayment pressure and an increasing need for rollover of the same.

India Inc. accounts for almost 90 per cent of this short-term debt, which includes trade credit repayment, corporate short-term bonds, repayments of FCCBs, ECBs etc. These will continue to exert further pressure on the rupee. “The system was becoming more vulnerable to external shocks, because the corporates were borrowing more from outside and were borrowing short term. When you borrow short term, your repayments become due. So, in a vulnerable system, even a slight shock can have a huge impact when you become more vulnerable”, says Joshi. As for the FCCBs, which are due for conversion this fiscal, it is highly unlikely that it would happen on account of weak equity markets. Major concerns come from the fact that greater risk aversion will make it equally difficult for Indian companies raising fresh debt, leading to a possible liquidity squeeze going forward.

NRI Remittances - The ray of hope comes in the form of NRI remittances, which form a major chunk of dollar inflows. NRI remittances are made by individuals who are living outside the country. These flows are quite huge, and are almost equal to India’s total IT exports, and also higher than India’s annual trade with the US. These funds mainly flow in during the last quarter of the fiscal. “There are a lot of remittances that take place in the last quarter from Indians working abroad. They are really our backbone, and help in narrowing down the current account deficit”, explains Haresh G Desai, Director, A V Rajwade & Co., leading risk management consultants in forex, interest rates and derivatives. NRI remittances to the country have steadily increased over the years, and in 2010, these inflows increased by close to 10 per cent to USD 52 billion (USD 49.47 billion). Once these funds start flowing in, it could bring in some rationality to the rupee levels from what is seen currently.[PAGE BREAK]
RBI’s Status Quo - Despite such a fall of the rupees vis-à-vis the US dollar, the RBI has not come forward to lend its support to the falling rupee. The reason for such non-interference might be the liquidity in the system, which currently looks a little tight. This can be gauged by the bids for repo in the liquidity adjustment facility that grew from an average Rs 17700 crore in the second week of September to Rs 70000 crore in the third week. Therefore, any intervention by the RBI in the current situation will mean the selling of dollars, which will result in sucking the rupee out of system and will further tighten liquidity.

Besides, the RBI’s hands also bound due to a sustained high current account deficit. Unlike its other Asian peers, like South Korea, Malaysia and Indonesia, which are running a current account surplus, India’s current account deficit during April-June 2011 widened to USD 14.1 billion from USD 12 billion in the same quarter of the previous year. To put this simply, India is importing more than what it is exporting, and hence requires US dollars to pay for the imports. Therefore, in the current global macroeconomic situation if the RBI intervenes in the forex market and sells dollars, it will put pressure on future payments.

Nonetheless, with advance tax for the second quarter already paid, and the government’s borrowing programme for the second half also declared, it will ease some liquidity. Therefore, we believe that the RBI may now start intervening in the market to reduce the volatility in the forex market.

Conclusion
To summarise, things aren’t going to be easy going forward. At one end there is the Damocles sword of uncertainty over the US and the Euro zone, which has not only led to massive wealth destruction in stock markets globally, but has made investors averse to higher risks. Investors are steadily dumping emerging markets and trying to look for comfort in the dollar, thus resulting in a comparatively stronger dollar. This is affecting capital inflows to emerging nations such as India, and the weakening FII and the FDI numbers are evidence of the same.

This is not all. It will be a double whammy for India, as the country also faces an economic impact of the depreciating rupee and the worsening situation in US and Europe. Lack of export demand denting forex earnings, and a swelling import bill are a recipe for disaster, and are bound to take a further toll on the current account deficit. Thus, for India, it is more of an economic impact than just the market impact that is currently witnessed by many other economies. As for the rupee, there are very few factors that favour the currency appreciating from the current levels, though there are ample reasons for it to stay weak. “The rupee should be in the range of Rs 48-49, but by December 2012, I would again put it at Rs 53-54”, says Desai.

Looking at the higher current account deficit and the slowdown in FII and FDI inflows, we believe that the rupee will remain weak for some time. Even if NRI remittances come to the rupee’s rescue, the quantum of short-term debt is quite high, and that should keep the rupee under pres-sure. Our sense is that even the RBI is currently taking a cautious approach, and may only intervene if the rupee goes beyond the Rs 52-level mark, simi-lar to what was seen in the second half of 2008. Therefore, in the absence of any strong support, we believe that the rupee should stay in the range of Rs 48-49 per dollar in the next six months.[PAGE BREAK]

An interview with Dharmakirti Joshi, Chief Economist, CRISIL

Why, do you think, is the rupee depreciating against the dollar?
I believe that there are two elements to it. One is the vulnerability of the system and the other is the shock. The system was becoming vulnerable to external shocks, because corporates were borrowing more from outside and they were also borrowing short term. If you ask me which is the more dominant factor, I would say that it is the vulnerability of the system. Otherwise, we would not have seen such a sharp depreciation.

Compared to the US or Euro zone, where worries are mounting by the day, India is still expecting a respect-able growth rate of 7-7.5 per cent. Why, then, is the currency depreciating?
What you are seeing right now is an impact of sentiments, and you are witnessing the fear of a dysfunctional financial sector. There is fear in the minds of individuals and corporates that they will not get dollars when they want it going forward, and that liquidity would become an issue. In the long run, my bet would be that the rupee would appreciate, rather than depreciating.

Could the probable double-dip in the US have a crucial impact on the currency going forward?
Yes, because that will have a deep impact psychologically. Actually, we can’t even trust the data that comes in, because the US recession in 2009 was actually much deeper than what it was earlier believed to be. The data was revised downwards significantly. There is a fear psychosis right now, and any bad news triggers these adverse events.

Historically, we have seen the rupee touch levels as high as Rs 52 to a dollar. Do you see that happening once again?
This can happen only if there is a genuine double-dip in the US and it is confirmed. Right now, I think some are anticipating a double-dip and some believe that the US is already in a double-dip. Our parent company, S&P, believes that there is a 40 per cent probability that there will be a double-dip in the US.

Coming to the impact of a depreciating rupee, how do you see this hurting us economically?
We are in a high inflation scenario right now. So, whatever benefit we could have got out of falling commodity prices gets neutralised. Secondly, as you know, we are huge importers on the oil front, and that has fiscal implications, as the government would have to shell out more in terms of subsidies. Third is the impact on those who import raw material and use them, for domestic production and consumption will be hurt more. What happens is that, they cannot pass on the rising cost of imports in the domestic economy because the demand is slowing. So, these are the categories which will get burnt more. However, there are always some winners and some losers. The winners will be the IT/ITES companies, who will temporarily gain out of this. Also, exporters will gain, but not too much.[PAGE BREAK]
The RBI has not intervened in this episode at all. In fact, their official line too has been that of non-intervention. Who, in your opinion, is supposed to intervene, if not the RBI?
I think the issue is that, you have reserves that are not very high and the import cover of those reserves has also declined. Now, in these circumstances, if the central bank gives a guarantee that it would defend the rupee at a particular level, they would be hedging for you. The central bank probably wants to send out a message to the market to ‘get used to the ups and downs and also hedge against the volatility – we are not going to guarantee any exchange rates, because volatility is a part of life, and we will intervene only when the slide is too sharp either way’.

Where will the current economic scenario lead us to?
As far as domestic policy is concerned, if the demand keeps slowing down, then the central bank will also rethink its policy. Right now, we are seeing inflation much above their tolerable level, which is true, and that itself can be damaging to the economic prospects of the country. The central bank’s ability to manage inflation is a key to the future growth prospects of the economy. If risks materialise again, it will not be a surprise if inflation touches zero again. There are only two good factors that have played out so far. One is that the monsoons have been good, and second, exports have done really well so far.

So, where do you see the rupee by the end of FY12?
India still remains a good growth story, despite the fact that growth has slowed down below eight per cent. It means that capital can give you higher returns here, so money should come back unless it is impaired by a double-dip in the US. Money coming back means that the rupee should see some strength, and that is why we see it coming back to Rs 46-47 to a dollar.

What do you see as the reasons for the depreciation of the rupee, and why did it happen so briskly?
The exchange rate is nothing but the price of the currency. If the demand for the dollar is higher than its supply, then the rupee should depreciate, and if it is the other way, it should appreciate.

Coming to the second part of your question, the first jolt came from the bunched up payment of the Iran oil. This got bunched up with the rating downgrade of the US, where the whole world got nervous, and very close to its heels were all the discussions happening on the European side. This led to a significant amount of risk aversion globally, which led to a reverse flow of currency to the safe haven of the dollar.

In the midst of all of this, there was this ONGC FPO, which was expected to bring in a lot of dollars, but when it also got pulled out it created nervousness, and people started short covering their position, which added to the depreciation pressure.[PAGE BREAK]
Is the scenario different now as compared to that in 2008?
At that time, the issues were totally different. The oil prices had shot through the roof, reaching around USD 147 per barrel by July 15, 2008. That was also the reason why the rupee was depreciating against the dollar so sharply, and therefore, the risks were becoming really apparent on the cur-rent account side. Then, when the crisis struck, obviously the whole issue of risk aversion played out again, and that really jerked the rupee back to around Rs 52 zone around March 2009, I believe.

Is there a difference in the degree of risk aversion that prevailed in 2008 and that which prevails now?
Today, it is a much more risky scenario, where we are talking about sovereign bonds. At that point of time, we were talking about consumer debt and mortgage debt. So, that problem was more isolated within the US. This problem is not only the problem of the PIIGS economy, but it is most likely to spread, if there is an ultimate default that happens from Greece.

So, risk aversion is the main reason for the rupee depreciation, and we don’t see much scope for this mess to get cleared very soon.
Why I am saying that we don’t see this mess getting cleared so soon is because nowhere in the model am I factoring in an ultimate default any-where before 2013. Now, the reason for this is the German and French banks, who have the heaviest exposure to the PIIGS economies, they are of very short-term papers which are maturing by 2013.

What, do you think, will the economic impact of all this be?
Again, it is a relative issue, in the sense that given the scenario the RBI is fighting against inflation, it may have some inflation dynamics attached to it. But I think from a growth perspective, an appreciating currency would possibly hurt your export side, and there-fore, reduce your growth. I would say that the inflation pressure would stay neutral, in the sense that we have also seen commodity prices dropping in dollar terms. Other than that, I don’t think that there is a tangible impact on the domestic economy per se, except for the fact that people who have near-term payables could be hit. So, that is other way of looking at it, where the private sector is getting hit out of currency depreciation. However, from a macro-economic perspective I don’t think there is a significant ramification of the depreciating rupee.

So, is that one of the reasons why the RBI has said it is not going to intervene?
It is a debatable issue. My clear stand is that the RBI clearly understood that the currency depreciation was more the global issue than a domestic issue, and hence the understanding was that there was no speculative attack on the currency. Now, if the country’s currency is not under speculative attack, there is no reason why the central bank should come out and defend it.

In the light of all this, they definitely wanted to keep their fire power dry, because this is a dynamic world and you cannot exactly time any melt-down that occurs. In the last time, if I recall, the RBI had to sell USD 18 billion in the single month of November, to prevent the depreciation and cover up for the outflows that were happening. This time, it could be higher than the USD 18 billion. In one shot you run the risk of losing a lot, and why should I try to fight against the global dynamic risk?

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