The Indian currency is in the limelight again, as escalating trade war, spike in crude oil prices and incessant fund outflows dragged it to a record-closing low last week. This chain of events is reminiscent of 2013, when taper tantrums, coupled with weak fundamentals, had made the Indian currency skid helplessly.
Most experts and analysts are, however, more sanguine this time, citing various factors, such as strong forex reserves, revival in growth and a more steady pace of decline in the currency and relative over-valuation of the rupee, to support their view that there is no cause for alarm.
Many of these arguments, however, appear weak if we take a closer look at numbers. Also, there is a structural change taking place in the global financial markets that could continue to exert pressure on the rupee.
Reserves may fall short
The RBI has been focused on building an arsenal of forex reserves since 2013 — from $275 billion in September 2013 to $408 billion towards the end of June 2018; 48 per cent higher. It’s however doubtful if this is adequate. Forex reserves are already down over 4 per cent in the last two months as RBI began battling against a sliding rupee.
The central bank has been using periods of strong foreign portfolio inflows to buy dollars to shore up the reserves. In the recent past, it net purchased $33 billion in FY-18 and $54 billion in FY-15. In both these periods, FPI flows into equity and debt were strong at ₹140,000 crore and ₹270,000 crore respectively.
Given that the rupee has declined 8 per cent since the beginning of FY-19 and FPIs have already pulled out ₹60,388 crore from Indian markets, the RBI might be unable to add to the kitty this fiscal.
There is also the risk that forex reserves can prove to be insufficient if there are sustained fund outflows. According to Bank of America Merrill Lynch, current import cover at 11 months, one-year forward, is above the eight-months cover that is deemed necessary. But this is much below the import cover of around 14 months before the 2008 financial crisis.
Increased dependence on FPI flows to sustain reserves, is also not comforting. Share of FPI investments has increased to 132 per cent of the forex reserves towards the end of December 2017, up from 82 per cent in 2008.
FPI flows can reduce
Of greater concern to the rupee is the reducing liquidity in global financial markets. The stimulus provided by global central banks, particularly the Federal Reserve, has been fuelling asset price inflation across the globe since 2009. As global central banks begin to move towards monetary policy tightening, flows into emerging markets can be impacted.
According to the IMF, the Fed’s monetary policy normalisation, raising the policy interest rate and shrinking the balance-sheet, can reduce portfolio flows to emerging market by about $70 billion over the next two years, which compares with average annual inflows of $240 billion since 2010. With other central banks such as the Bank of England and the European Central Bank also following suit, this can have a lasting impact on FPI flows in to the country.
Of the cumulative FPI assets in Indian equity and debt held as on June 2018, almost 80 per cent was added between 2009 and 2017, when global central banks were pumping liquidity. As this tap closes, it’s obvious that we need to re-think our forex strategy to adapt to the changing times.
Reduced inflows, coupled with inherent structural weakness, can maintain pressure on the Indian currency over the long term.
The rupee has been in a structural downtrend against the dollar over the last 50 years. The dollar-rupee rate was less than 10 prior to 1980 and the devaluation in the early nineties took the rate to 32 by 1993.
Barring the strengthening phase between 2002 and 2008, the rupee has been constantly losing ground against the greenback. The reason for this weakness has been the country’s trade deficit; this is unlikely to vanish given the country’s dependence on imported crude and problems plaguing export growth. Short-term bouts of volatility in the global currency market such as the recent one caused by the trade war and spiking crude oil prices will continue to impact rupee negatively.
Mounting external debt
Mounting pile of India’s external debt is another factor that is negative for the Indian currency.
With domestic banks reeling under stressed assets and the growing aversion to lending to corporates, Indian companies have been tapping overseas lenders to finance their short-term capital needs.
This has resulted in short-term portion of external debt going beyond comfort levels.
Commercial borrowings have increased from $41.4 billion towards the end of March 2007 to $202.3 billion by March 2018.
Similarly, short-term trade credit has increased from $28 billion to $100.4 billion. Of the total external debt of $529.7 billion, debt with residual maturity of up to one year accounted for $222.2 billion towards the end of December 2017.
Rupee depreciation will result in higher outgo when these loans are repaid.
Also, refinancing these loans could get difficult with increasing rates and tighter liquidity conditions.
What’s in it for companies
Share of short-term external debt of one-year residual maturity has increased to 69.6 per cent of forex reserves, if FPI investment in debt is included, according to Bank of America Merrill Lynch. It’s apparent that the rupee is likely to remain under pressure and the reserves are likely to prove inadequate if the trade war escalates or tightening global liquidity leads to accelerated FPI outflows.
While export-oriented sectors such as IT and pharma are likely to see their revenues improve with the falling rupee, other sectors that import raw materials could see their margins contract.
How a weak rupee will impact India Inc
IT and pharma gain while PSU oil marketing companies and aviation lose. With increasing globalisation leading to Indian companies expanding their global foot-print, their fortunes have become entwined with the rupee movement. Here’s a closer look at some of the key sectors that have been impacted by the weak rupee
IT gets a leg-up
Top-tier IT players such as TCS, Infosys, Wipro and HCL derive 55-65 per cent of their revenues from North America (mostly the US); for mid-cap players, the figure is around 60-80 per cent. The rupee has depreciated by around 6 per cent against the US dollar so far this fiscal year and would, thus, act as booster to margins, though the extent would vary across companies.
In general, a 1 per cent movement in the rupee vis-a-vis the dollar helps margins by 25-50 basis points for domestic IT firms.
For Infosys and TCS, every per cent fall in the rupee would add 30-50 basis points to the EBIT margin.
For mid-cap IT companies such as Mindtree, Cyient and Persistent, the benefits would be to the tune of 40-50 basis points for every one per cent depreciation of the currency against the dollar.
As the rupee has been on a steady decline against the dollar from mid-2011, IT companies have begun to go easy on their hedging strategies.
Infosys, for example, had a hedging position of about $1.5 billion as of March 2018, which is a little more than half its quarterly revenues. Mindtree had $41 million equivalent in hedges, which is less than a fifth of its quarterly revenues.
Much of the depreciation of the local currency has been from this April. Hence, IT companies may be able to derive the major benefits from the middle of the current fiscal. With pricing increases not coming forth from clients, a weak rupee may provide the much-needed cushion on margins for IT players.
Most IT stocks are already trading in the fair-to-expensive valuation zone.
Any further re-rating based on the rupee fall appears less likely.
(Contributed by Venkatasubramanian K)
Triple jeopardy for OMCs
The rupee’s rout compounds the troubles of the PSU oil marketing companies (OMCs) — Indian Oil, HPCL and BPCL. Rise in crude oil price and the rupee’s fall often feed into each other, and increase costs sharply for the OMCs. Add to the cauldron, the lack of pricing power during major elections, and OMCs find themselves hit by the triple whammy of rupee, oil and politics.
India imports more than 80 per cent of its oil needs and the fuel is among the country’s largest imports. Such heavy import dependence of a crucial commodity means that sharp price jumps in crude oil invariably raise concerns about the current account deficit going awry, weakening the rupee. Indeed, the weakness, in recent times, can be attributed, in fair measure, to the sharp rally in crude oil. A weak rupee, in turn, pegs up the effective import cost of crude oil for the OMCs in local currency terms. Had the OMCs enjoyed true pricing power, they would have passed on the cost increase by hiking prices of petrol and diesel. But in the run up to major elections, they go slow or freeze price hikes, in deference to the government, their major shareholder. With a hectic election cycle slated over the coming year, the pricing power of the OMCs may be constrained. The stocks are down between 30 and 50 per cent over the past 10 months.
PSU oil and gas exploration companies — ONGC and Oil India — should ideally benefit from the fall in the rupee and the rise in crude oil prices, as both these factors can mean an increase in their price realisations in local currency terms. The price of their oil output is pegged to the global oil price in dollars and then converted into rupees. But the Oil India and ONGC stocks too have slipped — between 20 per cent and 30 per cent since January. This has followed reports that the government may impose a windfall tax on these companies and pass it on to the OMCs to avoid petrol and diesel price hikes that are antagonising the public.
(Contributed by Anand Kalyanaraman)
Driving auto exports
The rupee’s 4-9 per cent depreciation against major international currencies so far in 2018 is both a boon and a bane for the auto and auto parts industry. On the one hand, companies that derive a chunk of their revenue from exports, are seeing improved realisations. Bajaj Auto, which derives 35-40 per cent of its revenue from three-wheeler and bike exports, realised an exchange rate of ₹67.2 for the dollar in the March 2018 quarter on exports compared with ₹66.9 in the three months ended December 2018.
The appreciation in the euro against the rupee is a tailwind for tyre manufacturer, Balkrishna Industries, which derives 55 per cent of its revenue from exports to Europe. For the year-ended March 2018, the company clocked foreign exchange gain of ₹221 crore on revenue alone and a net forex gain of ₹263 crore . This is more than double the gain recorded in 2016-17.
On the other hand, operating profit margins of vehicle manufacturers such as Maruti Suzuki are facing pressure due to costlier import of components/raw materials such as steel as well as more royalty outgo. The impact has been due to both commodity price rise and a weaker rupee against the yen. In the March 2018 quarter, for instance, royalty outgo increased by about ₹100 crore (including restatement of previous quarter) due to the appreciation of the yen. However, having reduced its import content in inputs to 12-15 per cent now from 25 per cent a few years ago, the company is in a much better position today.
Tata Motors (Jaguar Land Rover business), Motherson Sumi and Bharat Forge also have significant exposure to currencies such as pound, euro and dollars. Hence, they stand to be impacted due to sharp currency fluctuations as well.
(Contributed by Parvatha Vardhini C)
A booster shot for pharma
Many Indian large-cap pharma companies, including Aurobindo, Dr Reddy’s Lab, Lupin, Sun Pharma, Cadila and Glenmark, derive 60-100 per cent of their revenue from exports. The US is the key market for these companies, accounting for 32-50 per cent of their revenue. The overseas operations of Indian pharma companies have not been too good due to multiple headwinds, including heightened regulatory scrutiny and pricing pressure overseas. Once these concerns abate and niche opportunities are tapped over the longer term, these companies can see a revival in fortunes. Sustained rupee depreciation will further boost their prospects.
However, most companies have hedged only a small portion of their exposure, thus ensuring that gains from rupee depreciation flow to the bottomline. For instance, Dr Reddy’s Laboratories held hedging position worth approximately $255 million as on March 31, 2018. This is equal to 45 per cent of its quarterly revenue.
Given their strong foothold in other economies, pharma companies also buy hedges in other currencies such as ruble, euro and pound. Dr Reddy’s has also hedged positions worth about ruble 1,350 million. Cipla’s outstanding cash flow hedges as of March 31, 2018 were $141 million and ZAR 25 million. Some companies such as Natco Pharma have opted to leave their positions unhedged to make the most of a depreciating rupee.
On the other hand, rupee depreciation will increase the cost of raw materials for active pharmaceutical ingredient (API) manufacturers as they import more than 75 per cent of their inputs. A major part of these imports are from China, which are invoiced in US dollars. Companies that have a significant portion of their debt in foreign currency are also likely to be impacted by the higher dollar conversion rate, which results in higher interest and loan repayments. Aurobindo, Sun and Cadila are few companies holding higher debt.
(Contributed by Dhuarivel Gunasekaran)
Wings clipped for airlines
The March 2018 scorecard of airlines in India showcased the damaging power of a deadly combo — rising costs and low pricing power. Crude oil and, thereby, aviation turbine fuel (ATF) cost rose rapidly during the quarter. The rupee’s descent from 63 to 65 to the dollar added to the cost pain, and airlines lost pricing power due to ramp-up in fleet capacity and increased competition.
Fuel costs, as a percentage of sales, rose sharply for all the three listed airlines.
Result: they all did badly, a reversal from the good show during the prior three quarters.
Market leader IndiGo Airlines’ profit fell 73 per cent Y-o-Y; Jet Airways posted a big loss, and SpiceJet’s 11 per cent profit growth was much lower than in the earlier three quarters.
The rupee has only continued its southward journey since the March quarter and is now close to 69 per dollar.
Also, crude oil and ATF prices have only gone up.
These two factors feed into each other — rising global crude oil prices weaken the rupee, and a weak rupee adds to the fuel cost of airlines in the local currency.
ATF is first priced in dollars, based on import parity pricing, assuming that the ATF is imported into the country, and then the cost is converted into rupees at the prevailing exchange rate.
So, both rising global ATF cost and a weak rupee add to the airlines’ fuel bill.
At about ₹68,000 a kilolitre in Delhi (Indian oil prices) in June, ATF is about 45 per cent costlier than in July 2017.
With big capacity additions on the anvil, airlines could again lack pricing power to pass on cost increases arising from a weak rupee and elevated ATF prices.
(Contributed by Anand Kalyanaraman)