The Indian Rupee And Its Discontents

The Indian Rupee has caused a lot of heartburn. It is the worst performing currency in Asia and has fallen 17% against the US dollar since the start of the year. Some of the questions on people's minds with respect to the rupee are:

What has caused the fall in the rupee?
The immediate simple answer is that the fall is caused by flows driven by supply and demand. India runs a deficit on the trade and current account. This deficit is funded by a surplus on the capital (investment) account. Volatility in the rupee in recent years has increased due to the inrease in volatility in global financial markets and the consequent volatility in India's capital account. India's domestic environment hasn't helped the capital account either. Policy paralysis combined with an over-hawkish Reserve Bank of India (RBI) has caused a complete collapse in capital investment in India. This has exacerbated supply constraints and fueled inflation.

The increase in inflation causes a deterioration in India's trade and current account as India loses competitiveness in the global economy. This also causes the purchasing power of the Indian rupee to deteriorate and leads to lower nominal standards of living for Indians.

Is the fall temporary and how long will it last?
This question needs to be answered at two levels. Will the rupee fall further or strengthen and should the rupee fall further or strengthen? This divergence stems from the fact that the intrinsic value (should question) of the rupee is divergent from the nominal value (will question) of the rupee. In the case of foreign exchange markets, the divergence of nominal value from intrinsic value can be large, volatile and often causes changes in the underlying values.

India's economic and structural rigidity has increased over the last few years, reversing the trend of the early part of this decade. This has happened because all the slack and low hanging fruit in the system has been used up. Demand growth is hitting the supply constraint wall and political turbulence is causing the system to seize up. The clamor for goods and services in short supply has increased and is likely to accelerate going forward.

This is also taking place in the backdrop of a world that has become inflationary, driven by the reversal of the Chinese deflationary engine of the previous two decades. I therefore believe that on a purchasing power parity basis, the Indian rupee has eroded significantly in value. I don't know what the right level is. However, I think the range of INR 40 - INR 50 versus the US dollar has probably shifted out to INR 50 - INR 60 versus the US dollar.

The above is the damage that has already been done. If the economic investment environment does not improve, the purchasing power value of the rupee could continue to deteriorate further.

On the capital account, foreign investment into India appears to be bottoming out. Obviously if we have a complete collapse of the global financial system, things will get worse from here. However, if one assumes that the world will muddle-along then the likelihood that capital flows (portfolio and direct investment) will pick up in 2012 is high. Whenever that happens, it will cause the rupee to strengthen. Depending on the size and momentum of the inflows, the rupee could appreciate significantly. But the purchasing power anchor will keep forcing the rupee down into its lower range.

What is the impact of the volatility in the rupee?
This is the fun question. The media needs sound-bytes and tends to paint everything with the same brush. The impact will, however, be far from uniform. In the immediate short-run, companies with foreign borrowing and currency hedges are being impacted.

Even here, accounting rules require immediate recognition of all marked-to-market losses. However, for some companies, their assets are in dollars, their revenues are in dollars and their liabilities are in dollars, for these companies even as their debt is expanded and their P&L is impacted, their equity is not written up (which should be the case) creating a mispricing in the market. Examples are shipping and offshore drilling companies. Other companies have varying combinations of assets, liabilities, revenues and expenses in rupees or dollars. Each has to be studied on a case by case basis. At this time the markets are punishing everyone equally.

There are other companies which are import dependent and will have to increase domestic prices without any benefit to their P&L (and perhaps higher working capital requirements). However, there are those that will be able to increase import parity prices in the domestic market, who have domestic or captive (even better) raw materials and are able to benefit fully from the increased pricing power.

A lot of companies in manufacturing related exports like textitles that had become completely non-competitive will become more competitive and benefit.

In summary, I think (contrary to my earlier opinion), the weaker rupee is here to stay and volatility (both ways) of the rupee will continue. However, it is not all doom and gloom and every dislocation creates opportunities.