The Rupee on a Roll

The Indian Rupee (INR) is one of the worst performing currencies in the world during 2012 (Table-1). At Rs.55/USD it slid by 5% in 2012 (so far) after sliding down by a  whopping 19% during 2011. The month of May was especially devastating. Since 2000, the current rupee level is the highest ever seen (look at the graph). This has caught everyone by surprise including the RBI.

The following questions emerge out of this:

1.       Why did the rupee depreciate so fast?

2.       How does it affect various people?

3.       What is the further downside and where can it settle? &

4.       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. And when people sell rupees and buy dollars, it results in negative capital flows and leads to downward pressure on the currency (and vice-versa). The following reasons can be explored:

a.       Global Financial Crisis (GFC)

b.      Weak Indian Economy

c.       RBI &

d.      Corporate Debt and Hedge

Global Financial Crisis (GFC)

Ever since the US sub-prime induced Global Financial Crisis hit the world in 2008, things have never looked better for global growth. While US was firefighting the trouble, the Europe crisis started and engulfed the world. The GFC has reduced the global growth and has thus impacted emerging markets that depended on developed world for exports. While initially the impact among currencies was primarily between USD and Euro, it later on spilled over to other currencies including emerging markets.

Result: Investors flee other currencies and take shelter in US Treasuries (the so called safe haven) causing USD to strengthen and other currencies to weaken

Weak Indian Economy

Indian economy, after growing briskly during the last few years, is expected to slow down during 2012 and next. From a growth rate of close to 9%, the forecast now is about 6 to 7%.

Indian economy’s deficit is spiraling out of control. Both the fiscal deficit (expenditure more than income) and current account deficit (imports more than exports at a simple level) are headed for further deterioration during 2012 and next. While the fiscal deficit will hit 5.9% in 2011/12, the current account deficit will touch 3.9% of GDP during the same period. 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. Lack of progress in deficit reduction is causing poor foreign investor confidence which contributes to negative capital flows (meaning foreigners taking their money out of the country). The deficit is a long-term problem especially the fiscal deficit. No matter which government is in place, populist policies will continue as a tool to gain votes and this will ensure that the deficit does not come down. However, if they do not go up, then that itself will be good news.

Also, during the past few years, Indian government has attained notoriety for governance lapses (2G scam, etc) and policy missteps. Revising the IT Act retrospectively from 1962 in order to bring Vodafone to book was a huge blow to the confidence in our legal structure to foreign investors. Also, there were several governance failures that keeps India in the wrong side of the news globally (a good indication is the number of negative articles that appear in The Economist).

Result: Foreign investors exit by selling rupees and buying dollars

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. This may be due to limited foreign exchange reserves currently at $267 billion enough to cover only 5.2 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. While RBI has not interfered directly, it has taken several steps to contain the situation:

·         It now requires exporters to repatriate 50% of export earnings placed in special accounts

·         Limits on intraday net open positions of foreign exchange dealers

·         Restricting currency derivatives (to check speculation)

·         Hiking the interest rate on NRI foreign currency deposits as well as rupee deposits

Result: RBI has no arsenal to arrest the slide immediately but is using other indirect means very effectively so far

Corporate Hedge & Debt

Many Finance Managers, while managing their foreign exchange exposure, turned quite easy and relaxed due to continued rupee strength during the last few years especially during 2010 when rupee was averaging say 45 (you don’t need to hedge when rupee is strengthening if you are an importer and vice-versa). They expected this to continue forever and hence did not bother to hedge their currency risk exposures. Also, many of them resorted to foreign currency borrowing mostly in short-term maturities from European banks disregarding the rupee depreciation danger. However, when rupee started falling (much against their expectations) they were caught off guard and ran for cover to hedge their exposure which led to intense buying of dollars leading to its appreciation. Now many short-term corporate debt is coming up for repayment which will also witness more dollar buying adding to the rupee pressure. Also, the ability to rollover the debt will be limited by European banks due to the European crisis.

Result: Companies will have to find dollars to repay their debt and incur loss due to unhedged positions

2.     How does it affect various people?

A rupee weakness affects the following:

·         Importers (as they have to pay more rupees for the same dollar)

·         Economic image of the country (not able to arrest the fall)

·         Existing foreign investors (their investments are worth less now) &

·         Residents (in the form of say high oil price)

On the other hand, it benefits the following:

·         Exporters (as they get more rupees for the same dollar)

·         Non-resident Indians (NRI’s) (as they get more rupees for the same dollar)

3.     What is the further downside and where will it settle?

While domestic weakness in terms of low growth, high deficit, high inflation has contributed to the falling rupee, we should also blame the global financial crisis accentuating the problem for us especially Europe. This has caused many currencies in the world to fall (see Table 1, Brazil) apart from India. RBI is playing a sensible role of not exhausting our foreign exchange reserves and is allowing the market to determine the level of rupee. If required, it could call on SBI to raise external financing from NRI’s like how it did in 1998 and 2000 (remember the Millennium bonds!). However, the days of Rs.45 is gone. Political weakness is expected to continue with weak policy responses on all issues. There is no quick solution to deficit problems and inflation. Hence, on a balance of factors, the rupee may firm to Rs.51 or Rs.52 by the end of 2012 after hovering over the current levels for some time.

4.     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

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Currency	May-12	YTD	2011	2010	2009	2008	2007	2006
BRAZILIAN REAL	3.9%	6.5%	12.3%	-4.8%	-24.7%	30.0%	-16.7%	-8.6%
RUSSIAN ROUBLE	9.3%	-0.3%	5.3%	0.9%	-0.7%	24.2%	-6.7%	-8.4%
EURO	5.7%	3.3%	3.4%	7.0%	-2.3%	4.3%	-9.5%	-10.3%
UK £	3.6%	-0.9%	0.4%	3.6%	-9.5%	35.8%	-1.3%	-12.1%
JAPANESE YEN	-0.3%	3.4%	-5.2%	-12.6%	2.5%	-18.6%	-6.5%	0.9%
THAI BAHT	3.1%	0.5%	5.0%	-10.0%	-3.9%	16.1%	-15.6%	-13.6%
PAKISTAN RUPEE	1.5%	2.9%	4.9%	1.5%	6.6%	28.5%	1.3%	1.7%
INDIAN RUPEE	5.7%	4.9%	18.6%	-3.7%	-4.5%	23.4%	-10.7%	-1.9%
SINGAPORE $	3.2%	-1.6%	1.1%	-8.7%	-1.7%	-0.8%	-6.0%	-7.8%
CHINESE RENMINBI	0.6%	0.9%	-4.5%	-3.5%	0.0%	-6.6%	-6.4%	-3.2%
Note: Positive sign indicates depreciation and vice-versa Source: Reuters

Note: Positive sign indicates depreciation and vice-versa

PS: The author thanks Madhusoodhanan for data assistance

SIP’s: Makes Sense, but to Whom?

This article was published in The Global Analyst

If you have been investing through advisors, or basing your investment strategy on what you read in stock market magazines, you may probably have heard one or all of the below:

1.       You cannot and should not time the market.

2.       You should consider investing regularly (say monthly) so that you can take advantage of market volatility &

3.       Regular investments or Systematic Investment Plans (SIP’s) is easy and flexible and can inculcate savings habit.

To add to the emphasis, imagine you invested lump sum during Jan 2008 or November 2010 when Sensex was at its peak (20,800). At the current level (16,152) your portfolio would be down by 22%. Hence, the case for SIP.

Has SIP’s produced superior results to say a Buy and Hold (B&H) strategy? The table below tells it all.

During the last 8 years of analysis, SIP’s outsmarted a B&H strategy only 2 times. The SIP performance is Internal Rate of Return (IRR) method since it involves regular cash flows. For eg., you could assume investing Rs.10,000 every month for the last 3 years. The IRR of your investment at today’s Sensex value (assuming you cash out) would be an annualized return of 2.6%, while a B&H strategy would have yielded an annualized return of 21.5%, a huge difference of around 19% annualized. Except for the last one year and 4 years, the SIP performance lagged the B&H in all other time periods. The table depicts annualized performance; hence the opportunity loss value could be significant for longer time periods.

The idea of this analysis is not to critique market timing or discipline in investments. Of course, it is a known fact that it is difficult to “time” the market. Ideally we would like to buy low and sell high, but if we get our timing wrong, we will end up buying high and selling low. But the panacea to this is not systematic investments especially in a volatile asset class like equities as can be seen from the workings. In a consistently rising market, SIP’s can produce average purchase cost lower than the peak value thereby benefiting the investors. However, markets are rarely rising consistently and if they do so, the volatility will be far lower. Markets by nature gyrate between optimism and pessimism and hence produce volatility.

The best news for SIP’s lies with the fund houses which can aim for consistent and measured growth in their Assets Under Management (AUM) by enabling you to commit a fixed amount of investment every month. It is good news for them since they earn their fees on the AUM’s and not necessarily on how your investments have performed.

Also, once we sign up for a SIP, rarely ever we take the pain of monitoring its performance vis-a-vis a B&H strategy. Hence, SIP’s once started invariably runs its course, which again is music to the ears of fund houses.

The only argument in favour of SIP’s is that it is easy on your liquidity, especially if you have a monthly income matching monthly investments. However, given the findings, it may make more sense to commit an SIP to say a Post office Recurring Deposit (RD) or to a debt fund than to an equity fund.

The author would like to thank Madhusoodhan for data assistance.

Are you getting enough Salary?

Recently I read an interesting story on salary levels in the GCC region starting from a CEO all the way to the executive secretary. Saudi Arabia tops the list in terms of salary offer followed by Qatar. Kuwait and UAE rank in the middle while Oman and Bahrain rank lower.

Preferred work destinations for expat based on salary

Asian Expat	Arab Expat	Western Expat
Saudi Arabia	Saudi Arabia	Saudi Arabia
Qatar	Qatar	UAE
Kuwait	UAE	Qatar
UAE	Kuwait	Kuwait
Oman	Bahrain	Bahrain
Bahrain	Oman	Oman

The distribution of salaries across expat groups is interesting. Overall, Arab expats receive 25% more salary than Asian expats while Western expat receive 33% more than Asian expat and 7.5% more than Arab expat. However, sharp differences are noticed in individual job category. For eg., in Construction Project manager category, a Western expat will cost 65% more than Asian!

Asian Expat experienced pay increase in Bahrain while their salaries dropped in UAE. However, relative to Arab and Western expats, they experienced considerably lower increases across the board. For the Arab Expat, Qatar was superb with 30% salary increase in 2011 while UAE was flat

Western expats experienced the best gains especially in Qatar (27%) and Saudi Arabia (24%). The Arab spring must have increased the "risk premium" which seems more for expats than for Asians!

Interesting statistics to benchmark!

Effective Financial Risk Communication Beneficial for Investors

This article was originally published in Arab Times

Risk disclosures can convey to investors the nature and magnitude of significant financial risks and how well these risks are being managed. Following an earlier article in the Financial Times (FTfm supplement) Vincent Papa, director of financial reporting policy at CFA Institute, and Mandagolathur Raghu, President of CFA Kuwait, argue the recent crisis have heightened the importance of the quality of corporate communications about financial risk exposures and risk management. This is just as important in the GCC as elsewhere, as the region has battled a series of corporate failures due to the financial crisis.

 Where do the largest financial risks to companies arise?

Financial risk exposures arise from a number of factors including volatile currency exchange rates, interest rates and commodity prices. They also arise from complex financial instruments such as derivatives instruments and from debt instruments used in the capital structure. Different business models dictate a businesses susceptibility to different types of risk.  For example, Airline companies contend with jet fuel price uncertainty while mining companies have to contend with fluctuating commodity prices. Companies with global operations will likely face foreign currency risk. Banks are susceptible to credit risk during all phases of the economic cycle and credit risk primarily arises due to the possibility of borrowers failing to fulfill their obligations to banks.

Why are financial risks currently so high? 

For both financial and non-financial companies, financial risks are influenced by the economic cycle. For example, credit risk related losses typically materialise during strained economic environments when borrower firms and individuals are likely to be financially distressed. Credit risk can in turn exacerbate the funding risks faced by banks and cause problems refinancing the debt portion of the capital structure. For example, during the ongoing European sovereign debt crisis, European banks have suffered a significant reduction in the levels of wholesale funding available, especially short-term funding from US money market funds.  The recent crises also highlighted counterparty risk. Significant losses could occur during stressed market environments for the financial institutions that are net sellers of credit protection via credit default swap contracts (CDS). Another facet of counterparty risk is “wrong-way risk” where counterparties who have provided credit risk insurance cannot fulfill all their insurance obligations due to being financially distressed.

 How well do companies communicate about financial risk management?

Financial risk management can occur through many enterprise choices. For example, banks hold liquid assets to mitigate the risk that customers will withdraw their deposits. Banks can hold greater equity capital buffers to absorb unexpected losses. Additionally, risk management entails hedging activities that are undertaken to mitigate particular risks faced by companies. Hedging occurs through financial instruments such as derivatives and through economic hedges such as foreign currency revenue receipts being hedged by foreign currency borrowings. But companies are typically opaque about specific hedging strategies and this can result in investors only becoming aware of ineffective hedging strategies belatedly when losses are incurred.  This is especially true in relation to complex and synthetic hedging strategies.

 Are there specific financial risks that the GCC region is exposed to?

Since most of the GCC countries are pegged to the US dollar, currency risk is the predominant issue. While the much talked about GCC monetary union aspires to bring about a unified currency (along the lines of the Euro), it is still unlikely to mitigate the currency risk. Also, the GCC region comprises a number of major conglomerates that are predominantly family businesses. While in the past they carried enormous goodwill , popularizing the concept of “name lending”, the financial crisis has created some large scale corporate defaults drawing attention to this increased level of risk in the region. Lack of transparency and communication also exacerbates the problem in GCC. However, the non-development of a derivatives market may reduce this impact albeit marginally.

How can risk communication be improved through financial reports?

CFA Institute conducted a study on risk disclosures under international financial reporting standards (IFRS). The study made several recommendations for improving risk disclosures to convey useful and understandable information for investors. One of the key recommendations is that executive summaries should be provided for all key risk categories that any company bears. These summaries should be succinct and portray an entity-wide picture of key risk exposures and the effectiveness of risk management.

Another recommendation is that there should be an integrated presentation of related risk information. Such integration is particularly necessary for banks, where Basel III disclosures are often reported in a disparate fashion relative to the IFRS requirements. We also recommend sufficient breakdown of information, clear presentation of all quantitative details and significant improvement of qualitative disclosures, focusing on adequately communicating the company’s specific risk management strategies.

Regardless of the arsenal of choices employed to manage financial risk, high quality risk disclosures are required to allow investors to make a more informed evaluation of the effectiveness of risk management strategies. To this end, risk disclosures need to communicate sufficient detail about the nature of applied risk management strategies.