The following questions emerge out of this:

1. Why did the rupee depreciate so fast?
2. How does it affect various people?
3. What is the further downside and where can it settle? &
4. What should be the strategy?

Let me try and answer them one by one:

1. Why did the Rupee depreciate so fast?

Technically rupee depreciates against the dollar when people sell rupee and buy dollars. And when people sell rupees and buy dollars, it results in negative capital flows and leads to downward pressure on the currency (and vice-versa). The following reasons can be explored:

a. Global Financial Crisis (GFC)
b. Weak Indian Economy
c. RBI &
d. Corporate Debt and Hedge

Global Financial Crisis (GFC)

Ever since the US sub-prime induced Global Financial Crisis hit the world in 2008, things have never looked better for global growth. While US was firefighting the trouble, the Europe crisis started and engulfed the world. The GFC has reduced the global growth and has thus impacted emerging markets that depended on developed world for exports. While initially the impact among currencies was primarily between USD and Euro, it later on spilled over to other currencies including emerging markets.

Result: Investors flee other currencies and take shelter in US Treasuries (the so called safe haven) causing USD to strengthen and other currencies to weaken

Weak Indian Economy

Indian economy, after growing briskly during the last few years, is expected to slow down during 2012 and next. From a growth rate of close to 9%, the forecast now is about 6 to 7%.

Indian economy’s deficit is spiraling out of control. Both the fiscal deficit (expenditure more than income) and current account deficit (imports more than exports at a simple level) are headed for further deterioration during 2012 and next. While the fiscal deficit will hit 5.9% in 2011/12, the current account deficit will touch 3.9% of GDP during the same period. The current account deficit is triggered primarily by trade deficit (Export-Import). Not only our imports exceed exports, but even within the imports the dominance is by oil and gold imports, something very difficult to control. Lack of progress in deficit reduction is causing poor foreign investor confidence which contributes to negative capital flows (meaning foreigners taking their money out of the country). The deficit is a long-term problem especially the fiscal deficit. No matter which government is in place, populist policies will continue as a tool to gain votes and this will ensure that the deficit does not come down. However, if they do not go up, then that itself will be good news.

Also, during the past few years, Indian government has attained notoriety for governance lapses (2G scam, etc) and policy missteps. Revising the IT Act retrospectively from 1962 in order to bring Vodafone to book was a huge blow to the confidence in our legal structure to foreign investors. Also, there were several governance failures that keeps India in the wrong side of the news globally (a good indication is the number of negative articles that appear in The Economist).

Result: Foreign investors exit by selling rupees and buying dollars

RBI

Reserve Bank of India is tasked with ensuring the financial stability of the economy and hence is the sole inventor of the monetary policy. In the past, when currency encountered volatility or undue fluctuations, RBI used its foreign exchange reserves to intervene in the market (through purchase or sale of dollars) and thereby reduce the volatility of the currency. However, this time around, they raised their hand and declared openly their intention not to interfere in preventing the rupee slide. This may be due to limited foreign exchange reserves currently at $267 billion enough to cover only 5.2 months of imports. For China, it amounted to $2,884 billion and represented 21 months of import cover, a far comfortable situation to be in. Hence, we can clearly understand the predicament of RBI to intervene. While RBI has not interfered directly, it has taken several steps to contain the situation:

• It now requires exporters to repatriate 50% of export earnings placed in special accounts
• Limits on intraday net open positions of foreign exchange dealers
• Restricting currency derivatives (to check speculation)
• Hiking the interest rate on NRI foreign currency deposits as well as rupee deposits

Result: RBI has no arsenal to arrest the slide immediately but is using other indirect means very effectively so far

Corporate Hedge & Debt

Many Finance Managers, while managing their foreign exchange exposure, turned quite easy and relaxed due to continued rupee strength during the last few years especially during 2010 when rupee was averaging say 45 (you don’t need to hedge when rupee is strengthening if you are an importer and vice-versa). They expected this to continue forever and hence did not bother to hedge their currency risk exposures. Also, many of them resorted to foreign currency borrowing mostly in short-term maturities from European banks disregarding the rupee depreciation danger. However, when rupee started falling (much against their expectations) they were caught off guard and ran for cover to hedge their exposure which led to intense buying of dollars leading to its appreciation. Now many short-term corporate debt is coming up for repayment which will also witness more dollar buying adding to the rupee pressure. Also, the ability to rollover the debt will be limited by European banks due to the European crisis.

Result: Companies will have to find dollars to repay their debt and incur loss due to unhedged positions

2. How does it affect various people?

A rupee weakness affects the following:

• Importers (as they have to pay more rupees for the same dollar)
• Economic image of the country (not able to arrest the fall)
• Existing foreign investors (their investments are worth less now) &
• Residents (in the form of say high oil price)

On the other hand, it benefits the following:

• Exporters (as they get more rupees for the same dollar)
• Non-resident Indians (NRI’s) (as they get more rupees for the same dollar)

3. What is the further downside and where will it settle?

While domestic weakness in terms of low growth, high deficit, high inflation has contributed to the falling rupee, we should also blame the global financial crisis accentuating the problem for us especially Europe. This has caused many currencies in the world to fall (see Table 1, Brazil) apart from India. RBI is playing a sensible role of not exhausting our foreign exchange reserves and is allowing the market to determine the level of rupee. If required, it could call on SBI to raise external financing from NRI’s like how it did in 1998 and 2000 (remember the Millennium bonds!). However, the days of Rs.45 is gone. Political weakness is expected to continue with weak policy responses on all issues. There is no quick solution to deficit problems and inflation. Hence, on a balance of factors, the rupee may firm to Rs.51 or Rs.52 by the end of 2012 after hovering over the current levels for some time.

4. What should be the strategy?

Currency and interest rates are the hardest thing to estimate in financial markets. Hence, the best thing would be to hedge and not try and anticipate currency movements. Having said that, the following could be done:

If you are a domestic investor, you should focus on export oriented sectors like IT for investments. They will have a great year ahead.
If you are a non-resident Indian, this probably is the best time to remit money to India. If you have dollar investments, it will be wise to exit the position and remit the money back to India.

If you are a corporate in India with significant foreign exchange exposure (either as importer or exporter), it is time to have some sound hedge in place as currency volatility is only expected to increase than decrease.

Note: Positive sign indicates depreciation and vice-versa

Mr. M. R. Raghu,CFA, FRM is the Head of the Research Unit and Senior Vice President at Kuwait Financial Centre MARKAZ. PS: The author thanks Madhusoodhanan for data assistance