May 2014: Election 2014 and the Rupee

We would like to use this newsletter to talk about the rupee in context of the IT sector.

In the run up to the elections for the Lok Sabha in May, 2014, there has been much speculation about the rupee dollar exchange rate, which could potentially prevail, if there is a strong and stable government at the Centre. The rupee, on its part, had depreciated significantly in August – September, 2013 to as much as Rs 68 to the dollar amid all the pessimism on India, especially the very high current account deficit that the country faces. At its current reading of Rs 59 to the dollar, the rupee has appreciated 13% since then, based on some good policy action from the RBI in terms of encouraging rupee inflows and recently with the prospect of a stable government at the Centre.

At this point, it is a good idea to step back and look at the fundamental factors driving the value of the rupee vis-a-vis the US dollar. India is heavily dependent on imports, especially oil and gold imports. India runs a current account deficit, i.e. the gap between exports and imports of goods and services of roughly $60-70 bn every year.

This gap needs to be filled by foreign inflows, whether in the form of FII flows into equity and debt or in the form of FDI.

Over the last few years, India has received on average $16 bn in the form of FII equity flows, $3.5bn in the form of FII debt flows and $22 bn in the form of FDI. This is not, on aggregate, sufficient to fill the gap of roughly $ 60-70 bn that the country needs to bridge its current account deficit. The gap gets filled by suppliers credit for imports and bank borrowings / ECBs. At the same time, given the precarious condition that India was facing in August, 2013 in terms of a very rapid depreciation of the rupee and questions being raised about longer term sustainability, the RBI would be tempted to build reserves to absorb any large inflows that may come in the future and also to keep the rupee from appreciating too much in order to sustain the export competitiveness over the long term, especially in an environment of competitive currency depreciation by most countries.

On the other side of the equation is the depreciation to be expected in the rupee because of the inflation differential that India has with the United States. With the US inflation running at 2%, and India’s inflation averaging 5-7% over the long term,economic theory suggests that the rupee should depreciate at 3-5% p.a. over long periods of time. From 1993, when the rupee was first let to float on a partial basis, the rupee, at its current price of Rs 59 to the dollar, has depreciated at 3% p.a. since then. This is well within the range of expectations and would suggest that the rupee is not significantly undervalued at this point to warrant a large appreciation, as some quarters have been expressing in recent times. Needless to say, these euphoric views are diametrically opposite to the views being expressed by pessimists in August, 2013.

The fear of an appreciating rupee seems to be the reason that the Indian IT services companies have underperformed in recent times. Given the fundamental weakness of the Indian current account situation, we believe the hopes of a much stronger rupee in the near term do not seem justified and the IT sector presents a good hunting ground for us to pick undervalued investment opportunities at present.