Time for a lower rupee

A trader with a six-month horizon can target export-oriented stocks

Let’s look at a data paradox, which is actually not a paradox. India’s trade deficit has got worse and, unsurprisingly, the current account deficit (CAD), which is tied to trade, has also got worse. The trade deficit/surplus is calculated by totting up the value of goods exported versus the value of goods imported. The current account takes the trade numbers into account and also adds up export and import of services (IT) and ‘invisibles’ like tourism earnings and remittances. 

As the trade gap has widened and the CAD has increased we would at first glance expect forex reserves to drop and the rupee to become weaker. Those seem like natural consequences. In fact, forex reserves are at a record high. The rupee is also fairly strong, though it has been hit in the past week.  

The underlying reason for a stronger rupee and high reserves is simple. Foreign portfolio investors (FPIs) have pumped in money. However, as mentioned in earlier columns, the money is being allocated differently. 

Through 2016-17, the FPIs bought a net Rs 48,411 crore of rupee assets, including Rs 55,703 crore of equity and net sales of Rs 7,292 crore of debt. In the first half of 2017-18, FPIs bought a net Rs 1,05, 763 crore, more than double the commitment of all of last financial year. But, it includes only Rs 1,671 crore of equity and an enormous Rs 104,092 crore of debt. 

The FPI buying is keeping the rupee afloat. FPIs have been happy to buy rupee debt for several reasons. Hard currency money is easily available due to quantitative easing (QE) programmes and zero or negative policy rates across the US, Europe and Japan. Indian debt yields are very good. Given inflation at below four per cent, treasury yields of 6.25 per cent and corporate yields of nine  per cent are very attractive. There has been no perceived currency risk, given the strong rupee. 

But, if the FPI buying eases off, the rupee will come under great pressure. Higher trade and CAD will have some say and create downward pressure. The fiscal deficit is also likely to expand massively, beyond the Budget estimates. The Budget was made by ignoring the impact of the goods and services tax (GST). If the fiscal deficit hits four per cent-plus, as seems very likely, the macroeconomic balance sheet starts looking much worse. 
 

There’s also inflation trends. Both wholesale price inflation and consumer inflation have started climbing. This monsoon has been patchy — there’s been flooding in the east and northeast, ruining crops. There’s also been low rainfall, which will hit crop yields in key wheat-growing areas of western Uttar Pradesh and Punjab. Food inflation can zoom from negative to double digits quickly, given the discontinuous nature of food supplies. In addition, crude oil prices are edging up and high duties on fuels will add to inflationary impact. So, while inflation might stay within the bounds of the Reserve Bank of India’s tolerance, a rising trend means the central bank will maintain the current policy rates. Higher inflation with current nominal rates will mean lower real yields. 

At this very moment, the US Federal Reserve is considering unwinding its massive balance sheet and possibly hiking policy rates again. The European Central Bank is also said to be considering easing off its quantitative easing (QE) programme. Japan will continue with its own huge QE but several quarters of genuine growth could make the Bank of Japan tighten up as well. That will tighten hard currency liquidity and raise hard currency debt yields. 

A rupee downtrend might, in fact, have started, since it dropped from Rs 63.99/dollar a week ago, to Rs 64.53 last Friday (September 21).  We could see a situation over the next few months where rupee real interest rates go lower and there’s a clear currency risk, even as hard currency yields rise and hard currency liquidity tightens. That might induce FPI pullback. 

A lower rupee would be good for exporters, who could clearly do with a boost. In addition, it makes domestic manufacturers more competitive vis-a-vis imports. In the short run, however, this will probably trigger market corrections. So, the trader with a six-month perspective could start looking at shorting a weaker rupee and also target export-oriented stocks.