The rupee on a crash course

August 27, 2013

(Any opinions expressed here are those of the author and not of Thomson Reuters)

Given the kind of volatility in financial products and asset classes that we have seen in India and some emerging markets over the last few weeks, it’s likely to be a long winter for the Indian economy.

The rupee is at an all-time low against the dollar, FIIs are big sellers in Indian debt and equity markets, the Sensex is falling and bond yields have risen. Adding to India’s misery, there’s no sign of inflation easing or interest rates coming down in a hurry. The twin deficits – fiscal and current account – are at levels that could expose the economy to a potential rating downgrade.

The Lok Sabha approved the food security bill on Monday. The additional subsidy strain is simply bad economics and is like thumbing one’s nose at those already reeling under the effects of ineffective governance.

The rupee has lost more than 16 percent against the dollar so far in 2013, causing chaos in the domestic economy. Imports are costlier and the current account deficit is expected to rise. Rising fuel costs (due to currency depreciation) and inefficient supply chain management will ensure that inflation won’t go down in a hurry.

Higher fuel subsidies would lead to a higher fiscal deficit and a rise in India’s twin deficits could easily mean a potential rating downgrade of its economy – one that is not too highly rated anyway. Soaring inflation and high twin deficits would mean interest rates won’t come down soon, which in turn would make it unlikely for corporate credit growth and the capex cycle to turn around in the near future.

So where will earnings growth in the corporate sector for 2014-15 and beyond come from? GDP growth is at its lowest in the last five years. It may barely touch 5 percent for 2013-14.

It’s a mess the country could have done without and actually avoided. Faster and concrete economic reforms, stable tax regulations, efficient control of inflation and interest rates are among measures that could have ensured a robust GDP growth rate. Controlling the domestic subsidy burden and reducing non-Plan expenditure could have strengthened the economy’s financial parameters. Was this too much to ask for from a central government? Probably, particularly in an election year. Add a variety of scams – financial or otherwise – and you have a recipe to ensure foreign investors (both for FDI and FII investment) will want to stay away.

What could be the potential risks that the domestic economy, the corporate sector or the capital markets would be exposed to over the next few months?

– The U.S. Federal Reserve could announce a gradual but planned withdrawal of quantitative easing measures, causing a further run on emerging market debt and equities.

– Over the last quarter, FIIs have sold Indian debt holdings, but haven’t sold much in Indian equities. What happens when they do sell?

– A rise in global crude oil prices could act as a double whammy following the sharp rise in oil import costs due to a crashing currency.

– A potential rating downgrade by some global credit rating agencies will raise borrowing costs both for the government and the corporate sector.

– Corporate results for the September quarter will show losses for companies due to currency devaluation. Volatility in currency and capital markets also makes it difficult for companies to make business plans.

Is there a silver lining? Well, export-oriented industries will benefit to an extent from the rupee’s fall. Some IT and pharmaceutical companies will also gain.

The rupee at 66 against the dollar could make it attractive for NRIs to bring in their offshore funds. But FIIs books will show significant currency losses in their investments and FIIs may find it prudent not to sell Indian equities. This will help reduce the current account deficit.

Clearly, there are limited positives in the entire scenario. Very little may change, unless elections are announced soon and the winner gets a clear mandate.

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