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CFA level 3 candidate. Avid small cap and macro follower. Keen on a special situations and distressed investing. Currently seeking entry into the asset management industry. No prior professional investing experience. Follows New Value investing ethos.
  • This Is How The Rupee Tumbles 0 comments
    Aug 28, 2013 5:25 AM

    The recent tumble in developing market currencies made headlines on all major financial bulletin boards. The focus of this article is the Indian rupee. (click to enlarge)

    Fig 1. USD/INR rate

    (click to enlarge)

    Fig 2. India's current account balance since 1990

    The economic crisis caused GDP growth and risk adjusted returns to fall dramatically in developing economies. India's large and persistent current account deficit was bound to cause a devaluation of its currency. However, quantitative easing (QE) in the US and austerity in Europe resulted in a low risk adjusted rate of return in developed markets. Thus, in the pursuit of higher returns, investors were happy to ignore the weak fundamentals across developing markets.

    US yields are expected to rise with the winding down of QE and risk free rates will once again reach levels where investments in riskier developing markets are not necessary. The resulting capital flight due to this expectation is the biggest factor behind the tumbling exchange rates.

    This devaluation is driven by fundamentals: an unsustainable current account deficit and low risk adjusted return on investments. But the government's policy to stabilize the rupee is not senseless.

    1. The foreign (dollar denominated) debt for the Indian government stood at $346 billion as of December 2012, a devalued currency would make the interest payments on these loans much more costly.
    2. We can show that the Marshall-Lerner condition is not satisfied among India and its largest trading partners: the GCC and the US. This means a devaluation of the currency will adversely affect the current account balance. Highly inelastic import demand is the main cause for this.
    3. Weak global fundamentals (especially in Europe) mean that exporters cannot take advantage of a weaker currency since export demand is still limited.
    4. Attempts to strengthen the currency by raising rates and tightening liquidity (the RBI is on a weekly Rs.22 billion bond selling spree) should help tackle the country's rampant inflation (5.79% in July 2013).
    5. A weak rupee also raises the costs of subsidies for imported fuel and food which can worsen the already dire budget deficit and further increase headline inflation.

    (click to enlarge)

    Fig 3. External debt in million USD

    Most market participants however, will point out the following:

    1. Forward rates point to the rupee nearing 68 vs. the dollar in one year. Since this level is far above the current rate the government will have a hard time even containing the rupee's fall.
    2. The government will have to take on more debt to fund rupee purchases and keep risk free rates attractive. This will deplete foreign exchange reserves also.
    3. Raising interest rates will hurt India's GDP growth rate by making credit more expensive. GDP growth was just 4.8% in Q1 2013.

    Analysts are still expecting a rollback of the current currency support measures and a cut in rates.

    Indian elections are due next year and there is change of leadership at the RBI - a former IMF chief economist is taking the lead. The new leadership has to push through the vital structural reforms necessary to increase investor confidence and bring capital back to the Indian economy. Without these reforms the rupee could depreciate further once QE stops in the US and the EU finally comes out of recession.

    Right now the weak rupee is great news for India's numerous IT and outsourcing firms as well as MNCs with large divisions paying rupee denominated wages. The J-curve effect will kick in for these firms resulting in more contracts and higher profits.

    The losers are the Indian companies possessing a capital structure comprised of a large portion of foreign debt. Yields will rise as interest rates and interest coverage ratios fall. The required rate of returns for these firms will also rise as equity risk premiums rise, and thus their stock prices should tumble in the long term unless they can find cheaper sources of funds.

    For those of us who are not seers it would be wise to avoid speculating in the equity and bond market. But with near term volatility rocketing upward, an options based strategy can pay off brilliantly. It is difficult to be sure of how markets will respond to the expected depreciation: will they be elated at rising exports or morose about rising equity premiums? Consider using market neutral options strategies that are bullish on volatility.

    Other useful data

    (click to enlarge)

    Fig 4. Budget surplus/deficit as a percentage of GDP

    In Brief

    Parity conditions

    1. Simple Purchasing Power Parity points to a further ~3.8% deflation of the rupee against the dollar (~Rs.66.5 per USD by next year) if Indian inflation can't be reined in. (US inflation for July is 2% which is near average for the decade).
    2. Parity conditions further stipulate that the real interest should be equal across countries. But difference in real interest rates between India and the US stands at ~3%. Real interest rates in India are higher, so it's technically better to invest in India since real return is at least positive (US real interest rates were at -1.75%).
    3. However, the expected rise in the US interest rates and high risk premiums for investment in India means that the interest rates in India are still not attractive enough for global investors. India's high risk premium (3% country risk spread in January 2013) is well illustrated by Fitch's recent downgrade warning.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Additional disclosure: Initial draft on 23/08/2013

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