Gear your portfolio to gain from fall in rupee

Sovereign borrowing abroad could make the currency more volatile in the future

There are many implications to the policy decision to float forex-denominated sovereign bonds to fund borrowing. The initial amounts would be tiny relative to gross domestic product (GDP). So this is just a trial balloon for now. However, it will affect foreign portfolio investor (FPI) behaviour. The immediate FPI response to the Budget has been sales of rupee equity coupled with enhanced exposures in rupee debt. Bond market yields have eased slightly, and the rupee has strengthened.

FPIs invest in rupee debt as they reckon to come out ahead despite the exchange-rate risk. The rupee is liquid enough to hedge the tenure of a bond and still generate positive dollar returns. A sovereign forex bond carries less exchange-rate risk for the FPI, since the risk is borne by the issuer government. If the rupee falls, the government has higher costs.  

The government must, therefore, hope that the yield on a sovereign overseas bond will be low enough to make it cheaper than rupee instruments after covering exchange risks. The yield differential for treasuries (rupee treasuries versus US dollar or USD) is currently around 5 per cent higher for rupees. The rupee’s trading history (1991-2019) shows long periods of stability, interspersed with sharp devaluations and recoveries.

In July 2009, for instance, the USD-INR rate was Rs 47.79 and it is now at Rs 68.57. That averages out to a compounded depreciation of 3.7 per cent per annum in a decade. The depreciation is not smooth. There will be times when sovereign bonds will be much cheaper after covering exchange risks, and there will also be times when the government loses after covering exchange risks. In terms of behaviour, forex-denominated bonds may lead some FPIs to lower rupee debt exposure and opt for that instead. This could lead to redemptions putting downwards pressure on the rupee. FPIs will also start arbitraging rupee treasuries versus forex bond as the rupee fluctuates.

This will make treasury management trickier for Indian corporates with overseas exposures. That’s significant since India’s trade (physical imports and exports) is roughly 40 per cent of GDP and the trade balance is negative with imports exceeding exports by $176 bn in 2018-19.

Given customs duty hikes, a weaker rupee squeezes importers. A negative shift in perception towards emerging markets and a “risk-off” attitude could create further pressures on the rupee. For instance, there may be an escalation in the US-China trade war, or more tensions with Iran. Such scenarios lead to higher volatility in global markets and FPIs pull back into hard currency assets.

On the positive side, rupee interest rates and bond yields could drop as government borrowing reduces. That would make financing costs easier for domestic borrowers and facilitate smoother transmission of policy rate cuts by the Reserve Bank of India.

If the rupee is liable to drop over time, and perhaps, to exhibit more volatility, Indian investors should look to hedge by creating portfolios of overseas assets. They should also look for investments in export-oriented businesses that benefit from a weaker rupee. They must be braced importers with higher input costs and lower margins. Indian corporates, which have net exports, or high domestic financing costs will deliver improved performances in this situation.

Over time, if India does start issuing larger volumes of forex-denominated sovereign debt, treasury management will have to become more efficient across the board. News flow from anywhere can affect global markets and higher sovereign exposures may mean higher rupee volatility.

“Perfect storm” situations do arise. Think of 2008, or the earlier “Asian Flu” of the 1990s, or the crisis triggered by Greece’s policy mismanagement in 2010-11, or sundry Latin American defaults, or Russia’s default that bankrupted Long-Term Capital Management. 

The next event in this category–and there will always be such events–could hit the rupee harder. Does the RBI, and do corporates with external commercial borrowings, possess the expertise and flexibility to handle such situations? Smart investors can thrive in such situations. Every crisis eventually creates new investment opportunities. But Indian investors will also have to be increasingly global in their thoughts.

The trends are clear. The prime minister called this a Budget with a 10-year perspective. Well, assume that the rupee will trend lower over the next ten years as India increases overseas sovereign exposures. Your long-term asset allocation should be geared to deal with this trend.