Rupee rising

Inflation, lack of sterilisation instruments prompt RBI to cut $-buying

The sudden strengthening of the rupee is being interpreted by the market in two ways. One of them is that the Reserve Bank of India (RBI) is having a difficult time managing the dollar inflows in the absence of government securities in its portfolio to conduct open market operations. The second explanation is that the central bank wants to curb inflationary tendencies in the economy.

Let's take the first explanation. According to RBI data, its stock of government securities (including treasury bills) amounted to Rs 34,021 crore as on March 5, 2004.

That's down from Rs 1,17,308 crore a year earlier, which means that the reduction in the central bank's holdings of securities to the tune of Rs 83,287 crore was on account of sterlisation operations during the year.

Contrast the much lower Rs 24,541 crore reduction in government securities in the RBI's stock during the previous year. Clearly, the RBI's holding of government securities has been reduced dramatically, thanks to its efforts to sterilise the effects of its dollar buying operations. Hence the need for stabilisation bonds.

In fact, both these explanations are related. If the RBI is unable to mop up the rupees it releases into the market as it purchases dollars, money supply rises, with a lagged effect on inflation. And the rise in money supply has already exceeded the RBI's 14 per cent target for FY04.

The way out is to stop buying dollars, which is what the RBI seems to have done. Why is inflation a worry when the rise in the wholesale price index has fallen to below 5 per cent in recent weeks? The reason is that there are signs that inflation is being artificially held down, thanks to the elections.

The rise in international crude oil prices, for instance, has not been reflected in domestic fuel and LPG prices.

The recent diktat by the central government to steel manufacturers to reduce prices is another example, as is the Gujarat government's clampdown on the price of cement. The full brunt of the rise in prices will, therefore, be felt after the elections.

The other reason for inflation to rise is because of the base effect. While the wholesale price index showed a rising trend till the end of April last year, it started falling thereafter. The WPI was at 173.7 as on April 26, fell to 173 by May 31, and moved up very slightly to 174 by August 30.

During the May to August period, therefore, the current year's inflation figures would be higher due to the low base during the previous year. It makes sense, accordingly, for the RBI to let the rupee rise to make imports cheaper.

Will the rising rupee affect exports? Take the case of our merchandise exports to the US. These rose by 10.4 per cent in calendar 2003, compared to average annual growth of 9.5 per cent over the last four years, indicating that the rupee appreciation last year has had little effect on exports.

Software exports to be hit

Even as the March quarter draws to a close, it looks like the rupee is in for a strong finish. It has appreciated around 1.8 per cent so far this quarter, following the gain of 5.2 per cent in 2003.

Needless to say, Indian software players will be impacted-around 80 per cent of their revenues are dollar-denominated and since most of the business is done offshore, a big chunk of expenses are in rupees.

A stronger rupee, therefore, hurts margins apart from having an impact on revenue growth in rupee terms. According to Infosys, every appreciating rupee costs it 0.5 per cent in the operating margin, before accounting for gains from hedging.

The degree of impact will be higher for companies with a higher proportion of offshore work, and for those who have a higher dependence on the US.

Besides, with the rupee appreciating towards the end of the quarter, it will also result in translation losses on the dollar-denominated deposits held by Indian companies abroad.

Meanwhile, although billing rates have more or less stabilised, customers have so far resisted any hike in rates. Besides, increased contribution from BPO and other outsourcing projects will dilute overall margins.

On the costs front, manpower constraints could cause a jump in staff costs, although this may be partly offset by savings on SG&A expenses.

In summary, there are no signs of any improvement in margins and in that light, the pressure of an appreciating rupee is the last thing software players would want.

In the recent past, most majors have negated the impact using the rupee-dollar forward market, but this is not a permanent solution. In the words of Nandan Nilekani, CEO of Infosys, "While we are able to hedge that (appreciating rupee) on a short term basis with forward contracts, on a secular basis, it is a cause of concern." It's no wonder NSE's IT index fell 1.3 per cent on Wednesday, compared with a 0.25 per cent fall in the Nifty.

With contributions from Mobis Philipose