Economy & Finance

• The currency effect
  
  Since last number of decades, the Indian currency was on a one-way trip of depreciation as against major currencies of the world. For a long time, Indians believed that the trend was irreversible. Higher imports as compared to exports and meager inflow of foreign capital were the major causes of depreciation of the currency. Due to high imports of oil and essential commodities; and sluggish export growth, India had major current account deficits year after year. There was a limited inflow of foreign capital. Government had to regularly borrow foreign currency loans to bridge the gap. The remittances from Indians abroad were a silver lining but it could only partially helped to reduce the imbalance in the balance of payment position. The large trade gap could not be bridged and so the Indian currency kept on drifting year after year. High local inflation and reduced purchasing power also added to the woes of Indian rupee.
  
  Things started changing in the last decade and the change has become more visible in the last few years. Indian economy opened up. There was substantial investment of foreign funds in the Indian stock market. Foreign direct investment (FDI) increased gradually but substantially. This could control the drifting of Indian currency. The large capital inflow added to the foreign exchange reserves and that could allow the Reserve Bank of India to reduce the exchange controls. The controls against current account transfers were gradually removed. Now the rupee has become convertible on current account. It is further poised to be fully convertible on capital account transactions in the near future. Indian foreign exchange reserves have crossed $ 200 billion mark and the increase in the reserves is likely to continue for the years to come.
   
  Earlier the monitary authority in India believed in pegging of currency mainly against the US dollar and it was gradually allowed to depreciate. A few years back, the RBI decided to allow the Indian currency to float and the currency was influenced only by indirect methods of market operations like mopping up or releasing the foreign currency based on demand and supply in the market. In the initial days of such floating, the Indian rupee kept on depreciating against most of the currencies of the world. However, thereafter things changed. After reaching a level of Rs. 50 per US dollar, the rupee appreciated gradually against the US dollar with intermittent downward movements and now it has appreciated to an unexpected level of less than Rs. 41 per US dollar. In the meanwhile, the US dollar kept on depreciating against the major currencies such as Euro, Great Britain Pound and Japanese Yen. Over the years though rupee gained against the US dollar, it has gradually depreciated against most of the other major currencies. Majority of foreign currency transactions of India are denominated in US dollar and strengthening of rupee against the US dollar has substantial economic repercussions on India.
  
  Some of the effects of strong currency are as under –
   

• Cheaper imports
  
  Strong currency allows a country to import at cheaper cost. Cheap imports allow a country to import more, which can reduce the pricing pressure in the domestic markets and thereby reduce the rate of inflation. However, cheap imports make the domestic manufacturing more expensive in comparative terms and domestic suppliers can face competition, which can cause reduction of sale volumes and margins.
   

• Costly exports
  
  Strong currency makes exports more costly in international market. It can cause reduction of export volumes thereby badly affecting export oriented industries as well as service sector. Reduced exports can make more supply available in the domestic market, which can cause pricing pressure and reduce the margins of local enterprises. The costly exports may contribute to controlling domestic inflation, which is a positive factor only in the short run.
   

• Reduction of liquidity
  
  When there is an upward pressure on the local currency, the central bank of a country can buy the foreign currency to reduce the pressure. In the process the central bank acquires higher quantity of foreign currency and releases local currency in the economy, which can increase liquidity. High liquidity can cause high inflation but it can also boost domestic savings and investment, which in term can build productive assets. Reduced liquidity by operation of central bank such as borrowings programme can cause reduction of inflation but it has a risk of slowing down the economy of the country. So the central bank tries to optimize the position to avoid any extremes.
   

• Inflow of capital
  
  Strengthening of a currency can add inflow of capital, which can cause accelerator effect on the strength of the currency. Foreign money can come in the country in anticipation of currency gains, which can cause in turn upward pressure on the currency parity. However the reverse case weakens the currency. Large foreign exchange outflow can cause serious effect on the domestic economy as foreign investors can dump local currency and local currency assets without mercy.
   

• Effect on investment
  
  When the domestic currency strengthens, the investment in domestic market in terms of foreign currency becomes expensive. Domestic properties and equity markets becomes expensive for foreign investors though they can gain if the currency remains strong over a long term. As against this for local investor, investment in assets abroad becomes cheaper. If the strengthening of the currency is temporary and speculative in nature, first site of weakness in local currency can cause substantial outflow of capital and weaken the currency and the economy.
   

• Effect on business profits
  
  In the short run, business profits can have negative impact of strengthening of the local currency. Strong currency makes the markets more competitive for manufactures, traders and service providers and their margins can shrink. Rapid appreciation of a currency can affect the business environment in a country and therefore central banks are very cautious in allowing their local currency to appreciate.
   

• Effect on external debt
  
  When the currency appreciates, the burden of the external debt of the country gets reduced. The country obviously has to pay less local currency to repay the debt. The companies, which have borrowed foreign currency loans, gain on immediate basis as their accounts are marked to market rates. This has positive impact on their profits in a short run.
   

• Impact of rupee appreciation in India
  
  After aggressively sucking US $ for a very long time, the Reserve Bank of India has reduced its mopping up operations and thereby has allowed the US $ to drift against the Indian rupee. This policy is adopted to control the inflation in the country, which was the prime cause of concern and anxiety to ruling political parties. Once the inflation is reduced to less than 5%, RBI may step in to mop up US dollars and thereby stop the strengthening of Indian rupee against US dollar. Currently, the US dollar is not only depreciating against Indian currency but it is also depreciating against most of the other major currencies of the world due to its own economic reasons. This has added fire to fuel and the rupee has appreciated to its nine years high. I will not be surprised if the rupee appreciates further against the US $ and breaches 40 rupee mark for a while. However such a situation is not very beneficial to India in the medium to long term. With more than 7% appreciation of Indian rupee in the past couple of months, Indian goods have already become expensive in the international markets. The low margin commodity exports cannot survive in such a scenario and they will yield to the competition. Loss of India can be the gain of China and other Asian countries. Further, appreciation in the rupee can spell trouble to the margins of service exports such as software exporter, BPO, KPO services and call centres. They are already under cost pressure due to steady increase of cost of skilled man power in India over the last few years. The service providers may have to live with lower margins. Small and marginal players can be thrown out of business. Strength of the Indian currency can squeeze domestic profits and can affect corporate performance over the medium to long-term. I feel that sooner than later, RBI will step in and dollar will inch up. Apart from dollar, most of the other major currencies have also declined against Indian rupee in the last couple of months though they have strengthened against US $. It is likely that Euro and Great Britain Pound will keep their parity position vis-à-vis Indian rupee over the next few months and may post even improvement.
  
  Traditionally movement of gold is dependant on the movement of Dollar in international currency market. Weak dollar and high oil prices have not given great strength to gold in the recent months. Still the gold is holding steady. Contrary to my expectation, the gold has not moved up in April; but it has slightly declined. This has happened mainly because of strength of Indian currency against US dollar. The depreciation in gold prices is lesser than the depreciation in US dollar as against Indian Rupee. The expected rise of gold has not materialized but gold may appreciate to Rs. 10000 plus mark in the months to come. The investors may hold gold or even acquire the same in small lots at current price with a one year horizon.
  
  Though there were some apprehensions in the month of March about the prospects of April, Indian stock market is doing well. The expected good corporate performance for the last quarter ended on 31st March, 2007 has done the trick. There is no slow down in the international markets as well and globally the stocks are still gaining strength in spite of concern. Though many fund managers expect stock market to see the Sensex level of 13000, when the level will come is anybody’s guess. The growth trend in the medium term looks intact though its strength may dilute. It may be advisable to remain invested in stocks and book partial profits at the Sensex level of 14500 in small or medium cap stocks of the sectors such as textiles, commodities, hospitality, shipping, pharma and auto ancillary which are export oriented. Investors may do well to invest in selected leading stocks from industries such as telecom, capital goods, petrochemicals, Infrastructure etc. which have major import requirements and have limited export orientation. Investors will also gain by investing in the stocks of emerging markets through mutual funds or by direct equity investments to the levels permitted by RBI.
  
  Debt is strong and interest rates are not budging. Risk averse investors need not think of anything else but can remain invested in fixed deposits and fixed maturity plans of mutual funds for good medium term returns.
   

• Conclusion
  
  The appreciation of Indian rupee is going to change the equation at least for a short run and investors should revamp their portfolios to suit the changing scenario.