The Mega Rupee Slide: Is the worst over?

The Indian Rupee (INR) is the worst performing currency in the world during 2011 (Table-1). At Rs.52/USD it slid by a whopping 17% during 2011 and 6% in November alone. The following questions emerge out of this:

1.       Why did the rupee depreciate so fast?

2.       What is the further downside and how low can it go? &

3.       What should be the strategy?

Let me try and answer them one by one:

1.     Why did the Rupee depreciate so fast?

Technically rupee depreciates against the dollar when people sell rupee and buy dollars. There are four reasons cited for this:

a.       Economy (both global and domestic) and Trade

b.      Stock Market

c.       RBI &

d.      Corporate Hedge

Economy & Trade:

Indian economy, after growing briskly during the last few years, is expected to slow down during this year and next. From a growth rate of close to 9%, the forecast now is about 7 to 7.5%. This is on the back of global slowdown and other associated problems.

Indian economy’s deficit is spiraling out of control. Both the fiscal deficit and current account deficit are headed for further deterioration during this year and next. While the fiscal deficit (not counting the states) is headed towards 4.5%, the current account deficit is projected at $44 billion or 2.6% of GDP. This is in sharp contrast to China which is expected to post a Current Account surplus of $305 billion or 5.2% of its GDP.  The current account deficit is triggered primarily by trade deficit (Export-Import). Not only our imports exceed exports, but even within the imports the dominance is by oil and gold imports, something very difficult to control.

While this is the domestic story, the global events are not too encouraging either. Both the US and Europe are struggling with one crisis after another with no solution in sight. The US lawmakers are finding it difficult to arrive at a consensus on deficit reduction. Any stalemate on this will make investors exit high yielding emerging market assets in favor of US Treasuries which means buying more dollars. This is technically the reason why USD is appreciating even though USA is in deep mess.

Stock Market:

The Indian stock market is down by 20% for the year on the back of poor global market sentiments and sagging earnings. However, the key to stock market performance has been the liquidity which to a great extent depends on Foreign Institutional Investors (FII’s). For FII’s, their overall return is a function of both stock market performance and currency performance. In other words, a great scenario for them would be a good stock market and appreciating currency. On the flip side, a lousy combination would be to have a negative stock market and depreciating currency. For eg. If stock market slides by say 25% and currency depreciates by say 10%, then the total loss is 35% in dollar terms which is a double whammy.

FII’s have been significantly ramping up their inflows in the Indian stock market during the last several years (Table 2).  However, trouble in US and more recently in Europe has increased their risk aversion and this resulted in sharp drop in foreign inflows in Indian stock market during 2011. This reduces demand for rupee leading to its depreciation.

RBI:

Reserve Bank of India is tasked with ensuring the financial stability of the economy and hence is the sole inventor of the monetary policy. In the past, when currency encountered volatility or undue fluctuations, RBI used its foreign exchange reserves to intervene in the market (through purchase or sale of dollars) and thereby reduce the volatility of the currency. However, this time around, they raised their hand and declared openly their intention not to interfere in preventing the rupee slide.

In a way such a clear cut communication is good as at least market players can guesstimate the likely outcome, but such a declaration is also an open invitation for speculators to short INR. More importantly let us understand as to why RBI has adopted such a “no intervention” policy. It is a strategic choice. If RBI thinks that the problem is temporary and hence any small intervention can bring the equilibrium back, then it is worth taking the risk. However my assessment as to what RBI thinks on this subject is that it expects the global economy to further deteriorate and hence it may not want to waste the precious foreign exchange reserves ahead of time only to be a lame watcher towards the later part of the episode.  For 2010/11, the foreign exchange reserves totaled $282 billion and represented roughly 7 months of imports. For China, it amounted to $2,884 billion and represented 21 months of import cover, a far comfortable situation to be in. Hence, we can clearly understand the predicament of RBI to intervene.

Corporate Hedge:

Many CFO’s turned quite easy and relaxed due to continued rupee strength during the last few years. They expected this to continue forever and hence did not bother to hedge their currency risk exposures, especially if you are an importer. However, all of them were caught off guard by the turn of events due to which they ran for cover to hedge their exposure which led to intense buying of dollars leading to its appreciation. On the other hand, exporters are still watching and waiting for even more fall so that they can reap a windfall.

2.     What is the further downside and how low can it go?

The rupee has clearly caught everyone by surprise by its fast slide. When you look at comparative numbers for other emerging markets and developed markets (Table 1), this slide is indeed very sharp and unexpected. Research agencies and investment banks now say that if RBI does not step in, then Rupee can further slide to Rs. 55 or even Rs. 57 by the end of the year.

However, to get a long-term trend,  let us revisit the four points explained above and see how they will evolve as we move forward:

	Analysis	Assessment
Economy	It is very clear that global growth will struggle for the next few years. However, India is not an export-dependent economy like China. It is a consumption-led economy. Hence, even in this gloomy global scenario, we can expect Indian economic engine to roar at 7% minimum. Hence, we are on strong turf on this.	POSITIVE
	The deficit is a long-term problem especially the fiscal deficit. No matter which government is in place, populist policies will ensure that the deficit does not come down. However, if they do not go up, then that itself will be good news. On the other hand, the current account deficit may come down in the future primarily because of rupee depreciation. Importers will either reduce their imports or hedge while exporters will ramp up exports to take the best advantage of a weak rupee. This may turn the trade deficit to more favorable terms which will in turn reign in the CA deficit.	NEUTRAL
Stock Market	FII investments will not come back unless some calmness returns to US and Europe financial markets. And without their strong inflows, there is no way stock markets are going to get their insulin. However, we should also not forget the fact that there are very few investing opportunities around in the world today. Hence, at the instance of first signs of stability in the global economies, liquidity will start flowing once again to emerging stock markets especially India. This may not happen in 2012 but will eventually happen in later years.	NEUTRAL
RBI	RBI, with just 7 months of import cover in terms of foreign reserves, does not have the fire power to prevent a rupee slide. Also, RBI actions are always short-term and cannot produce long-term directional change to the fortunes of rupee. Also, the RBI actions of late to control inflation have met with huge failure raising its credibility and ability to pursue and implement sound policies.	NEGATIVE
Corporate Hedge	The current slide can be partly attributed to the rush to cover the exposure. With the erratic behavior of the currency, finance managers and CFO’s will be wiser to hedge future exposure which may prevent volatility. Also, the depreciation of rupee will help increase exports which will bring in the much needed USD.	POSITIVE

Hence, as we can see, all factors are either neutral or positive with only RBI being on the negative assessment. This means that there isn’t more danger on the downside to the rupee.

3.     What should be the strategy?

Currency and interest rates are the hardest thing to estimate in financial markets. Hence, the best thing would be to hedge and not try and anticipate currency movements. Having said that, the following could be done:

If you are a domestic investor, you should focus on export oriented sectors like IT for investments. They will have a great year ahead.

If you are a non-resident Indian, this probably is the best time to remit money to India. If you have dollar investments, it will be wise to exit the position and remit the money back to India.

If you are a corporate in India with significant foreign exchange exposure (either as importer or exporter), it is time to have some sound hedge in place as currency volatility is only expected to increase than decrease.

Table-1: Currency Performance

Currency Against USD	Nov-11	YTD	2010	2009	2008	2007	2006
BRAZILIAN REAL	3.5%	9.3%	-4.8%	-25.2%	31%	-16.6%	-9%
RUSSIAN ROUBLE	1.2%	2.1%	0.7%	-0.7%	24%	-6.8%	-8%
EURO	-1.5%	0.4%	-6.5%	3.2%	-5%	10.9%	12%
UK £	-2.0%	-0.2%	-3.0%	12.3%	-28%	1.7%	14%
JAPANESE YEN	-1.7%	-5.1%	-12.9%	2.7%	-19%	-6.2%	1%
THAI BAHT	0.8%	3.3%	-9.6%	-4.1%	3%	-6.8%	-12%
PAKISTAN RUPEE	1.4%	1.9%	1.6%	6.6%	28%	1.2%	2%
INDIAN RUPEE	5.9%	16.6%	-3.9%	-4.5%	24%	-10.9%	-2%
SINGAPORE $	2.1%	1.8%	-8.8%	-2.6%	0.09%	-6.2%	-8%
CHINESE RENMINBI	0.1%	-3.6%	-3.3%	-0.1%	-6%	-7.0%	-3%

Source: Reuters

Note: Positive sign indicates depreciation and vice-versa

Table-2: FII inflows

Rs cr
Financial Year	Equity	Debt	Total
1992-93	-	-	13.4
1993-94	-	-	5126.5
1994-95	-	-	4796.3
1995-96	-	-	6942
1996-97	-	-	8574.5
1997-98	5267	691.1	5957.2
1998-99	-717.2	-867	-1584
1999-00	9669.5	452.6	10122.1
2000-01	10206.7	-273.3	9933.4
2001-02	8072.2	690.4	8762.6
2002-03	2527.2	162.1	2689.3
2003-04	39959.7	5805	45764.7
2004-05	44122.7	1758.6	45881.3
2005-06	48800.5	-7333.8	41466.7
2006-07	25235.7	5604.7	30840.4
2007-08	53403.8	12775.3	66179.1
2008-09	-47706.2	1895.2	-45811
2009-10	110220.6	32437.7	142658.3
2010-11	110120.8	36317.3	146438.1
2011-12 (till Sep30, 2011)	2209.3	6478.8	8688.1
Source: SEBI

PS: The author thanks Humoud Al-Sabah and Deivanai for data assistance

Equity risk premium provides financial markets insight

This article was originally published in Arab Times

Capital may loathe uncertainty, but in the wake of the sovereign debt crises in the United States and Europe, it is equities that have borne the brunt of the selling pressure compared to heavily indebted countries’ government bonds, which in some cases have even gained in value. This is all the more true for the GCC capital markets which is devoid of any reasonable long-term bond benchmark. Combined with the relatively short history of equity markets in this region makes it even more difficult to compute an equity risk premium for GCC with some authority. Following an earlier article in the Financial Times (FTfm supplement) Jason Voss, Content Director of Fixed Income, Behavioral Finance, Quantitative Methods and Corporate Finance at CFA Institute and Mandagolathur Raghu, President of CFA Kuwait analyse the equity risk premium, a metric that helps explain this paradox—and that also provides important clues about the relative riskiness of stocks versus bonds in different market environments.

What is the equity risk premium?

The equity risk premium quantifies the additional rate of return that investors require to compensate them for the risk of holding stocks as compared to holding a “risk free” asset.  Equity investors require this additional return because equities come at the end of a business’s cash claimant line.

How is the equity risk premium calculated?

There is no universally agreed upon method to calculate the equity risk premium, but one simple way is to compare a given equity market’s earnings yield, defined as the inverse of the market’s price-to-earnings ratio, to a sufficiently long-dated government bond. In the United States, the equity risk premium can be computed as follows:

ERP = Earnings Yield of S&P 500 – Yield on 10-year U.S. Treasury Note

Why is the equity risk premium important now?

The sovereign debt crises unfolding on multiple continents highlight the intimate relationship between an investment’s returns and its risks which the equity risk premium helps to describe.  When Standard & Poor’s downgraded the sovereign credit rating of the U.S. last summer, for instance, U.S. Treasury prices rose while stocks fell precipitously. Since U.S. stocks are inherently riskier than Treasuries, any increase in the riskiness of government bonds means that riskier assets, such as stocks, should also reflect these increased risks.  In fact, the equity risk premium expanded just after the downgrade.

How did recent market events in GCC affect its equity risk premium?

Global events and the sharp run down seen across GCC stock markets will have affected the equity risk premium in recent times in two ways. Firstly, with GCC capital market predominantly dominated by retail investors who trade using bank funding, the absence of available liquidity avenues will have also increased the equity risk premium demanded by investors. Secondly, the political upheaval in some GCC countries will also be an issue for foreign investors, who in spite of vast foreign reserves in the GCC will demand higher risk premium.

How has the equity risk premium varied historically?

Based on S&P 500 data compiled by Yale University economist, Robert Shiller, the equity risk premium has averaged 2.45% from January 1881 through September 2011. Over that period of time, the equity risk premium has been as high as 15.84% (in December 1920) and as low as -4.38% (in January 2000).

 Can the equity risk premium be negative?

Logically, it may seem that the equity risk premium should never be negative. After all, in that scenario, investors could simply sell their equity investments and buy “risk free” sovereign bonds that would pay a higher return. Yet over the 130 years of equity risk premium data it has actually been negative roughly 25% of the time. One explanation for periods of negativity is that equity investors expect rapid earnings growth for the entire stock market to compensate them for the additional risk of holding equities. This would result in the bidding up of share prices and a consequent decline in the equity risk premium.

What other insights can the equity risk premium provide?

A negative equity risk premium seems to be an indication of when stocks are relatively overvalued. In fact, in the equity risk premium history considered, it turned negative for the first time in the exact three months that preceded the Great Crash of 1929.  Immediately thereafter the equity risk premium was again positive for many decades until September 1965 amidst the ‘Nifty Fifty’ period when it again turned negative.  From this moment forward the equity risk premium was negative for 75% of the time until December 2007.

Interestingly, transitions between positive and negative equity risk premium seem to be correlated with turning points in economic history.  Examples include transitions during each recession of the last 46 years and the 1973 OPEC oil embargo.

At the individual stock level, a negative equity risk premium is a quick method of assessing valuation.  The more negative the equity risk premium, the higher the growth of future earnings must be to properly compensate an investor for the additional risks assumed.

What does today’s equity risk premium level suggest about the future direction of the U.S. stock market?

Since January 2008, the equity risk premium has been positive for the longest period of time since the mid-1970s, suggesting that recent stock market performance—considered by many to be disappointing—is not unusual, but rather consistent with the historical record.  Further, it implies that the paradox of a negative equity risk premium, persistent for much of the last 40 years, has reversed itself.  As of September 2011 the equity risk premium was 2.99%, strongly in line with the historical norm and suggestive of fairly valued equities where excess returns may be unlikely.

NJY - Unparalleled Visionary

An innocuous looking email a few days ago shattered me completely. Sanjeev, my good friend, informed me about the untimely demise of Shri N.J.Yasaswy-the icon that built an institution called ICFAI. He was only 62. In my 23 years career, he was my boss and mentor for 5 years.

He changed many lives, including mine. He challenged conventional wisdom. He displayed and infused confidence. He took wild risks and never feared consequences. He personified knowledge and commanded respect for only this reason. He shared his knowledge constantly. He generously offered his advice. He valued time and was obsessed with punctuality. And he did all of this with a smiling face.

Personally he taught me several important lessons in life. There was the time when we were setting up a new concept and it involved dealing with several institutions. It was then that he said "there is nothing called an institution. Everything boils down to an individual. Identify that individual and talk to him/her and you can get your way". He also said, "if you are looking to recruit someone to assist you, make sure he is smarter than you. This is the only way you can build a great institution"

On another occasion when a colleague said that it would be difficult to do the thing he suggested, he retorted saying "we are here to do difficult things not easy ones". Then when the same gentlemen countered saying it would take time, he retorted again by saying, “a busy man always finds time; only a lazy man complains!" He pushed each one of us all the time and you now see the result- a gigantic institution, ICFAI, built with not a penny of assistance from banks or financial institutions, but with only internal accruals.

The man had a great personal side too. There were many instances where he would exhibit a phenomenal sense of humor ,so much so that on one occasion, i needed to walk out of the room since i could not control my laughter. He was humane and did not fear to show it. While we were traveling for business to Mumbai in Indian Airlines, NJY was sitting on the aisle and diagonally opposite the aisle was a young lady with a toddler. Obviously the toddler was giving the lady a hard time due to which her tea spilt down. The air hostess, instead of trying to be helpful, started reprimanding her for the act. Though we were engrossed in a discussion, NJY did not fail to miss the predicament of the young lady due to the unhelpful air hostess. In a fit of anger, he asked the air hostess to place her tea tray in front of him and said to her "you will not serve tea to any passenger till you apologize to that young lady" -and he meant it! This then brought the inflight cabin manager to the scene to whom he objected her behavior and reminded her that her salary was being paid for by all the passengers. Normal service resumed after an apology by the air hostess to the young lady. We encounter such scenes in our daily lives but largely choose to ignore them- but not NJY.

We shared many dais together and have lectured several programs. I will deeply miss him, as will the huge ICFAI family that he built. May his soul rest in real good peace.

M R Raghu