India had forex reserves of $294 billion on March 30. Of that, a considerable portion consists of hot flows such as portfolio investments by FIIs. Around $28 billion of reserves consists of gold held by the RBI.
India also has an external debt of about $335 billion. About 19 per cent is rupee-denominated so that's not a problem. About 23 per cent is short-term debt. Roughly one-third of the total external borrowings are corporate debt.
Most corporate debt consists of ECBs (External Commercial Borrowings). Some is in the form of FCCBs (foreign currency convertible bonds). The creditor may agree to convert an FCCB into shares at a given price. If the creditor chooses not to convert, the borrower has to repay in hard currency.
The ECBs should not be a major problem to service though forex will be required. The FCCBs may cause more stress. Many corporates issued FCCBs assuming conversions to equity. Unfortunately the terms were decided when the stock market was high. Agreed conversion prices are at huge premiums to current share prices. Redemption is thus, likely for the $8 billion or so of FCCBs due within the next 9 months.
India's current account deficit and trade deficit are both at significant percentages of GDP. The trade gap is widening. In percentage terms, those numbers are worse than 1991-92. The Current Account Deficit will be above 3 per cent for most of 2012-13. It was around 4.3 per cent of GDP in December 2011. It was just about 3 per cent in 1991.
Imports, which grew at 22 per cent in the last quarter, are unlikely to slow much in the new fiscal, despite the customs duty hike on gold imports. Crude forms the lion's share of imports and global crude prices appear unlikely to drop.
There's an upper boundary to export growth, given the weak global economy. The latest figures show that goods exports grew at only 8 per cent in October-December 2011 versus 39 per cent in Oct-Dec 2010. Key flows like IT services and NRI remittances are holding up but unlikely to grow at great pace.
If everything goes wrong there could be another Balance of Payments crisis. This seems very unlikely. Current reserves cover 90 per cent of external debt and about five months of imports. For an actual crisis to arise, we'd need a set of events to occur. The FIIs would need to pull out in a hurry, NRI inflows would have to stop, and exports slow down even as the price of crude spikes. Taken together, this is low probability.
However, in a business-as-usual scenario, the rupee will come under pressure. In fact, a scenario where the rupee doesn't come under pressure is difficult to envisage. It would require, among other things, a drop in crude prices, a revival in export growth, and higher levels of FDI and FII inflows. This “sweet spot” scenario is also low probability.
It would be reasonable to expect that the rupee will fall and perhaps, fall considerably, from current levels over the next 6-9 months as the situation plays out. That sets up obvious trades. A lot of traders will be going long USD-INR to try and take advantage of the above chain of logic.
The rupee's decline won't be a one-way move. The rupee is not a freely-traded currency. The RBI has plenty of tools at its command to shore it up. However, the domestic situation, with a large fiscal deficit and a massive government borrowing programme, doesn't give too much room to manoeuvre. The central bank can't hike policy rates for instance. Nor can it really sell huge quantities of forex since that would make the reserves situation precarious. So, the rupee should decline, with occasional sharp upwards corrections, as and when the RBI intervenes.
Trading currency futures or currency options involves a lot of leverage – amounting to 50:1 or more. While the currency trades could be extremely profitable, that high leverage also makes them quite risky. Managing such high leverage positions over the long-term takes nerves and experience.
Investors can also look at the other implications of a weaker rupee. Any export-oriented business is likely to gain in a scenario where the rupee loses value. Conversely any business with major forex outflows will see its balance sheet under pressure. Obviously industry and company specific factors will play a role in differentiating worthwhile investments. But this is a good starting point for seeking “alpha”. Companies that are forex earners should outperform the overall economy in the next two or three quarters.
