Indian Rupee's Future In Dilemma?

Includes: INR
by: EurEx Consulting

Indian Rupee - Future in Dilemma?

India is one of the major G-20 economies. In 2012, it was ranked as the 19th largest exporter and the 10th largest importer in the world. However, recently there has been a steep decline in its growth. The policies of the Reserve Bank of India (RBI) have ticked the clock back to two full decades of the Indian economy.

The rupee, as well as India's economic model is now on the ventilator. The INR, as against US Dollar (USD), has toppled the 69-rupee mark, with a drop of over 48% in the currency. India's Current Account Deficit (CAD) is not a new thing. For years now, the balance of payments has been financed by the Foreign Institutional Investor's (FIIs) and the Foreign Direct Investment (FDI) - the foreign money. The country's GDP has dropped from 9-10% two years ago to a 4-6% window in this year, a 50% fall in the economic growth in three years' time.

Reserve Bank of India's contribution to the Carnage

Firstly, there is an inelastic demand for oil, defense, food and gold, to name a few, and also a curb on the imports of these. The RBI has tightened links between the imports and the exports. The ban on gold imports and a rise in the import duties with a devalued rupee has bounced back on the treasury and has resulted in the ballooning CAD. Alongside, the RBI has done nothing to promote exports that would fill up their pockets with foreign currency. Also, the depreciation in the rupee, which drove up the main indicator of inflation - the Wholesale Price Index - by 5.79% from 2012, has worst hit the middle-class population of the country with an increase in food and oil prices.

The RBI has been constantly trying to squeeze liquidity to stabilize the currency as against the USD. The RBI hiked interest rates by 400 basis points above Libor, and the short-term interest rates by 200 basis points. As these rates made loans expensive for the corporate firms, they instead looked to the foreign markets for external borrowings, which enabled them to produce cheap, un-hedged financing at 3-4% due to the quantitative easing. With the decline in the INR, the companies were on the brink of bankruptcy.

With the price stability and the CAD in mind, the RBI was aggressive, which led them to announce policies that cut down Overseas Direct Investments (ODIs) from 400% to 100%. Also, overseas remittances were cut from $200,000 to $75,000 per year. This has restricted local companies and individuals to own assets abroad. This has also restrained Indian businesses from extending operations in foreign markets and from other mergers and acquisitions.

The depreciation in the rupee caused foreign investors (whose investments were denominated in USD) an approximate average loss of 20%. Additionally, the smaller-than-expected increase in the country's GDP and the terror of a weakening economy has instigated foreign investors to draw about $11.6 billion from the Indian capital markets. The foreign investors continue to extract money from the country on the basis of 'unclear policy inaction' by the RBI. The RBI seems confused about policies relating to the liquidity in the economy - to tighten the liquidity or to inject $1 billion in the market.

The Role of the United States

The US Fed is talking about exiting the financial stimulus, or on cutting down on the package. The Economic Stimulus Act of 2008 was passed in the United States to combat the recession. Under the Act, the low and middle-income groups were given tax rebates, incentives were given to stimulate investments and the brackets for limits imposed on mortgages were increased. Developing countries (including India) will be adversely hit if the Fed lifts such stimulus, as such an action will lower foreign investments from the US.

The second important factor that is strengthening the USD is its recovery from the 2008 recession. Though slow, the States are now growing at a steady pace. Besides, the government is successfully identifying the genes that could trigger growth and give substantial boost to the market (e.g. US trade competitiveness in knowledge intensive goods, increased investment in infrastructure, shale-gas and -oil production).

The growth in the economy is back on track and this is the major reason why FIIs are exiting from the Indian markets. The US bond yields trading at its two-year high has already given a substantial return compared to other emerging markets. Meanwhile, the rising dollar against the rupee is also motivating the foreign investors to pull out the money to cover their losses in the Indian markets.

The Relaxant - What should change the Investor's perspective?

The Finance Ministry of India is now banking on its FDI flows from the "big-ticket deals" that are scheduled for this quarter, emerging from the depreciated rupee and de-valued companies. A domestic airline set-up permission to Air Asia, Baring Pvt. Equity Asia's plans of buying stock in Hexaware Technologies, Etihad's stake acquisition in Jet Airways are some of the big shots that will bring in foreign currency into the Indian economy soon. The government has announced that the CAD will be capped at $30 billion, all funded from the FDIs and other inflows. It does not plan to use its foreign exchange reserves to finance its deficits.

The Finance Minister of India says that the cuts on the ODIs are temporary and can be reversed once there is price stability in the market.

As far as the External Commercial Borrowings (ECBs) are concerned, the RBI has now allowed repayment of rupee loans from the ECB proceeds for industries that receive foreign earnings (like infrastructure, hotels etc.) through the ECB Approval Route.

India will recover - it already has!

The steep upward move in the USD - INR has resulted in a loss of trust in the currency. However, INR has been stable around the 64 rupee to 1 USD mark in the last few days. This may be due to the aforementioned announcements by the Finance Minister regarding the RBI policies. Through the long-term perspective, the depreciation of the rupee and the decline in the growth of the Indian economy is a structural problem, and can solely be mended with a change in the government policies.

The current valuations of the Indian stocks are very near to their long-term averages. Presently, IT and software companies are the top gainers in the Indian market. Markets are volatile and will remain so till the general elections next year. However, this should not be a concern to a long-term investor. The economy, and the currency, is likely to recover by March next year. Alongside, if the RBI cuts interest rates in the recent future, it will send a positive signal to the market regarding its monetary easing, which will trigger the earnings. Also, the prospects for investment growth as compared to the market expectations look quite optimistic.

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

Business relationship disclosure: The article has been written by Analysts at EurEx Consulting. EurEx Consulting is not receiving compensation for it (other than from Seeking Alpha). EurEx Consulting has no business relationship with any company whose stock is mentioned in this article.