What is rupee depreciation? And its effects on stock investors
Indian stocks are valued in Indian Rupee (INR) and foreign ownership accounts for nearly 18%-20% of Indian markets. Hence, the value of INR against US Dollar (USD) vastly affects stock market investors.
Before we discuss this further, let’s revisit some currency basics.
- Currency is a powerful barometer to gauge the temperature of economic activity in a country. The stronger the economy and its prospects are, the stronger will be its currency and vice-a-versa.
- Currency, be it of any country in the world, follows a simple principle— the more it protects your purchasing power, the stronger it becomes.
- In the modern world, two factors largely affect the value of a currency—the rate of inflation and indebtedness of the country.
- A depreciating currency is often associated with two deficits running high—the fiscal and trade deficits. The former tells you how much a government is overspending, i.e. deficits in its budget, while the latter hints at a country’s export competitiveness and import dependence.
- USD is the world’s reserve currency and any large-scale sell-off in global markets creates a high (but temporary) demand for USD. If this is coupled with rising interest rates in the US, the US becomes a magnate for global investment flows.
On this backdrop let’s now evaluate the present situation.
The INR has depreciated around 8% from the beginning of 2022 and has been making new lows against the US Dollar (USD) nowadays. Some experts believe there is more pain left and they are predicting that the INR could touch the 82-83 mark against the USD.
Is this a cause of concern? And how will it affect your portfolio?
First of all, let’s see the factors responsible for the rupee depreciation:
- Rising inflation globally
- Federal Reserve’s unprecedented interest rate hikes in the US
- Rising crude oil prices
- Russia-Ukraine war
- Sanctions by western countries on Russian exports
- Rising bond yields
- Sell-off in global risk-assets such equities and cryptocurrencies
- Supply-side constraints due to lockdowns in China
A rise in the dollar index has been breathtaking and the US currency has made double digit gains in 2022 so far.
For those of you who came in late, dollar index measures the strength of the USD against a basket of 6 major currencies of the globe—Euro, Japanese Yen, Swiss Franc, British Pound, Canadian Dollar and Swedish Krona.
The Euro and Japanese Yen have recently touched their lowest levels in the last 20 years. But you will be surprised to know that the Russian Rouble has emerged as one of the strongest currencies of the world.
So, INR isn’t falling in isolation and external factors are primarily responsible for the recent slide. In fact, over the last 10 years, the Rupee has depreciated 3% every year on an average against the US Dollar.
How does a fall in the Rupee affects the economy?
Since India is a big importer of crude oil, the falling rupee works as a sentiment dampener. A combination of rising crude oil prices and a falling Rupee, as prevails at present, acts as a double whammy for the country. Volatility in fuel prices creates a spillover effect and often gives rise to high domestic inflation.
If it is followed by hikes in interest rates and dwindling profitability of corporates, India becomes an unattractive destination for investors.
Any skewed depreciation can create second-order effects such as the government imposing curbs on non-essential imports. It may cut-back spending to avoid larger deficits—another factor responsible for the valuation of currency as we discussed earlier in this article.
The RBI tends to intervene heavily if the INR extends its fall in excess of 8%-9% in a year. The actions include but aren’t limited to encouraging Foreign Currency Non-Resident (FCNR) deposits, selling USD in the forward market and allowing greater participation of Foreign Portfolio Investors (FPIs) in the domestic debt markets.
Similarly, it doesn’t favour unwarranted appreciation either since it is detrimental for India’s exports. An unprecedented rise in INR can make Indian exports unattractive.
Under such circumstances, the RBI may consider trimming USD holdings in its reserves.
In short, appreciation or depreciation in the value of the rupee should NEVER be seen in isolation. Unless you evaluate the rupee’s relative strengths, any figure against the USD is just a number.
If you remember, between May 2013 and August 2013, the Indian Rupee crashed 21% from Rs 56 to Rs 68 against the USD.
What were the factors responsible for the rupee depreciation then?
- Intervention of global powers in the Syrian civil war
- Climbing oil prices
- Federal Reserve’s signaling the end of quantitative easing
- Rising US dollar
- Rising treasury yields in the US
By the way, did you notice: The Rupee making new lows often coincides with rising interest rates in the west, rising inflation, rising crude oil prices and external crisis such as war.
Back in 2013, policymakers and businesses were equally concerned about the strength of the Indian currency. But despite the Rupee almost touching the Rs 80-mark against the USD now, hardly anybody (except a few media voices) seems to be greatly perturbed. Why?
The Indian economy is stronger today than it was in 2013 and therefore more able to absorb shocks in the external economy.
Whenever the Rupee makes a low, don’t forget to check two important indicators—trade deficits, foreign exchange reserves. It’s noteworthy that India had a lower import cover in 2013—i.e. foreign exchange reserves availability to meet imports—than now.
The 5-year average of India’s monthly merchandise imports is USD 40.9 billion which rose to USD 51 billion a month in FY22. India had foreign exchange reserves of USD 613 billion at the end of FY22 which have now declined to USD 593 billion. Still they are adequate to meet one year of India’s merchandise imports.
Currency depreciation makes imports costlier. Hence you should always check the level of import cover.
Since India is a net services exporter, we haven’t considered that number but to know the exact level of deficit/surplus trade balance, you should consider merchandise trade as well as services import/export numbers.
And this could be your action plan when the INR is depreciating:
If you are a long term investor:
• You should avoid any knee-jerk reaction
• You will be better off focusing on asset allocation
If you are a trader (in the equity markets):
• You may take a tactical view of the situation and avoid companies relying heavily on imports
• And also those with a massive foreign currency debt
• Under such a scenario, companies with good bargaining power and a huge export market tend to do well
Here’s a pro tip: If Rupee depreciation is coupled with rising crude oil prices, any exhaustion in the rising trend of crude oil may signal a probable reversal trend in INR. At such a point, you should start closely monitoring the movement of FPIs.
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