Rupee to remain strong

MARKET INSIGHT

The infrastructure sector is not only capital-hungry; it is also import-intensive and gains from cheaper imports.

A lot has been said about the ways in which rupee-appreciation hobbles export growth and adversely affects the trade balance. It's true. However, the other side of the story has not been highlighted and taking a macro-view suggests that the advantages to a strong rupee may actually outweigh the pain it causes exporters.

India imports about 70 per cent of its petroleum and gas and demand is growing rapidly due to the strong economy. With crude near $90/ barrel, imports will outrun exports for the foreseeable future. In these circumstances, a strong rupee is more a blessing than a curse. Domestic inflation stays under control despite energy inflation. Government finances are not totally crippled by petro-subsidies.

The RBI's forex inflow management has created a feedback loop. Foreign investors have brought dollars into India, secure that the rupee will appreciate - so long as the dollars keep coming. FII inflows have kept the stock market valuations buoyant. There is ample overseas interest in FDI targeting infrastructure as well.

Both FII inflows and FDI are vital for the long-term. Planning Commission estimates suggest about $500 billion must be pumped into infrastructure creation over the Eleventh Plan (2007-12). Such vast sums cannot be raised without tapping both domestic household savings and external funding in a big way.

The only realistic way to tap household savings is through infrastructure IPOs and that requires a booming secondary market. That in turn, requires net FII buying.

A one-way bet on the rupee encourages FIIs and also FDI and therefore enables rupee flows into the primary market as well.

The RBI may be compelled to continue its current management style until the general elections. The central bank has three imperatives; curbing domestic inflation; ensuring the investment tap for projects isn't turned off; trying to prevent currency appreciation. Due to politics, inflation is no:1 priority and currency appreciation a distant no:3.

So, the rupee is likely to remain strong. Despite the PN hiccup and increasing political uncertainty, net flows into Indian assets are likely to remain positive. Over the next five years, infrastructure will continue to show supra-normal growth and creates a compelling case for forex inflows.

Most infrastructure sectors are not only capital-hungry; they are also import-intensive and gain from cheaper imports on that score as well. Construction equipment, drilling equipment, telecom equipment, airline fleets, compensations to expat workforces, dredging tenders are just some random examples of likely areas of forex-absorption.

A strong rupee may also have a silver lining for export-based industries. The last time the rupee was at Rs 39-40/ USD in 1998-99, knowledge-export industries like IT and pharma were growing at near triple-digits. The dropping rupee then cushioned exporter bottomlines through the next 7-8 years and may have caused complacency.

Coping with a stronger rupee may force exporters to climb the value-chain. It may also induce them to exploit the vast potential of India's domestic markets. And, depressed valuations may also give investors a chance to enter good businesses at basement levels.

Overall, a stronger rupee is not unhealthy. In any case, it is also inevitable unless the change in PN policy causes such panic that FIIs actually turn net negative over the long-term. That is unlikely because of the growth story.

Given everything, infrastructure is liable to offer excess returns through the next five years and IT is likely to underperform until the rupee-dollar trend changes. It's possible to create portfolios holding these contrasting assets. Themed-funds are usually very high risk. However infrastructure is a very broad theme, it's not just one industry. Most of the AMC majors have at least one infrastructure themed fund available. All have given returns hat vary from good to great. Given the shape of the Eleventh

Plan, this pattern is likely to continue.

Meanwhile, IT could continue to underperform and offer lower returns until the exchange rate trend reverses. If we make the reasonable assumption that the best Indian IT firms are sufficiently well-managed to cope with adversity and become stronger, this is a great time to invest systematically on a contrarian basis. By the time momentum starts slowing in infrastructure returns, IT stocks could be providing positive gains.

There are plenty of IT"�themed funds as well. Most people would consider exposure into that sector insane at the moment. But it could be a good counter-cylical hedge for somebody whose primary portfolio is infrastructure.