Impact of the Falling Rupee

A flurry of articles has reiterated the benefits of low interest rates on capital expenditure and the invigorating effect of a depreciating Rupee on our economy.

 In photography, a wide angle lens is the preferred tool for capturing a landscape. I present herewith an attempt to paint the wider economic landscape in relation to these two variables.

Interest Rates

 Economic theory is broadly summarised as: High real interest rates reduce viability of investments and thus deters fresh capital spending. At the same time it incentivises savings and thus applies a break on consumption. A combination of falling investment and low consumption slows down an economy. The cycle reverses with cheap money igniting an investment boom.

Central Banks use this to modulate inflationary pressures in an economy

 Indian context

 

For the purpose of this article let's define inflation as the difference between nominal and real GDP growth rates. Thus defined, inflation has averaged 6.1% from FY2000 to FY2013 while nominal interest rates have averaged 6.8%. Thus average real interest rate has been 0.7% as compared to average real GDP growth of 7.2% over this period.

Real interest rates in India are not high in context of GDP growth.

For companies comprising the BSE 200 index, interest cost as percentage of sales is 6.5%. The top 10 companies in the S&P CNX Nifty have ~ USD 28 bn in surplus cash balances.

Reliance Industries, always the maverick, is borrowing at lower rates in foreign currency and investing in Rupee debt. For FY2013, 27% of PBT comprised of income from such interest arbitrage.

Incremental Capital Output Ratio (ICOR) may not be an appropriate indicator for this analysis. However it can provide a broader direction for further thought. The Planning Commission estimates ICOR for India’s service sector at 2.95. With 60 % of India’s GDP being contributed by services, clearly capital intensity for a large part of India Inc. is low. In comparison manufacturing and agriculture have ICOR’s of 6.48 and 5.32. This should reduce the impact of interest rates on capital expenditure decisions at least for the services sector.

Hence interest rates alone cannot explain the dip in investments

Exchange Rates

The Rupee remained broadly in the 45 to 47 band from the year 2000 until September 2011. As per World Bank, India’s exports increased from 13 % to 22 % of GDP during this period. From September 2011 till date our currency has depreciated approximately 29%. Net exports (including services exports) in absolute terms have increased from USD 303 bn to USD 363 bn between 2011 and 2013.

For TCS, India’s largest software services company, net profit margins have improved by only 54 bps from 2011 to 2013. Most of the gains from currency seem to be passed back to customers.

Clearly Rupee depreciation does not provide a sustainable booster of competitiveness for Indian Industry.          

Law of unintended consequences is hard at work in India. The depreciating currency does not help India gain market share in the global exports and conversely it acts as a mechanism for wealth transfer by transferring Indian wealth, in terms of purchasing power, to foreigners.

Here

Here’s how it works

The Rupee has dutifully depreciated at a CAGR of 7% since 1970. This constant slide adds to inflationary pressures. From 1990 inflation has averaged 7.6%. Both inflation and currency depreciation erode the purchasing power of savings.

A slight difference between the two is that inflation occurring due to domestic supply constraints transfers purchasing power within the economy. On the other hand currency depreciation transfers purchasing power from domestic savers to foreigners. This transfer of wealth is unrecorded and uncommented in popular press. The Indian middle class has been put on a treadmill where it slaves away to maintain its wealth, never achieving higher economic well being. At today’s exchange rate (59.35, as I write) India’s GDP for FY2013 stands at USD 1.67 trillion v/s FY2012’s USD 1.87 trillion. Accordingly GDP per capita has reduced to USD 1399 from ~USD 1560 in FY2012.   

The aforementioned case of TCS is another classic example. TCS’s operating margins improved by only 2.53% v/s 29% depreciation in the Rupee. This would imply that buyers are very sophisticated and negotiate contracts which reflect current exchange rates. Net gains to our economy therefore will be smaller than the amount of depreciation and limited only to exporters, who comprise less than 20% of GDP.

The currency’s decline stokes inflationary pressures in the domestic economy; further reducing purchasing power of domestic savings. The most impacted are the middle classes and pensioners with fixed incomes and limited assets. The poor bear the worst brunt of inflation in their daily lives. Their loss of wealth is limited only due to their small savings block.

The moneyed class usually diversifies its wealth in a mix of physical and financial assets. Since asset values adjust for inflation over a period of time, they are less impacted. However physical assets do not guarantee net gains.

The perennial currency decline and high inflation have reduced the citizenry’s faith in their own currency and drives its lust for physical assets a.k.a gold and real estate. Therefore it is not surprising to find that gold prices in Indian Rupees shows a secular uptrend over extended periods. Gold remains the next best option to preserve purchasing power, if one cannot own dollar denominated assets.

Exorbitant real estate prices are perhaps the largest contributors to lack of competitiveness. A fine example is the cement industry. Until a few years ago, land cost for a green field project used to be around USD 5 / ton out of a total cost of USD 100 to 105 / ton. Today land constitutes USD 15 to 20 / ton on an overall cost of USD 115 / ton.

India’s imports of oil, fertilizer and defence goods are inevitable. A falling exchange rate leads to ever increasing import bills. Since 60% of petroleum demand is subsidised and therefore inelastic, it inflates the subsidy bill. A policy favouring declining exchange rates seems faulty at best.

For the stock market, impact is twofold. On a mark to market basis portfolio’s of Foreign Institutional Investors (FII’s), register losses due to exchange rate fluctuation. In some cases, these could trigger stop losses which lead to immediate liquidation of holdings. A longer cycle of adjustment begins where inflationary pressures of wages and commodity prices have to be passed on. A lot of mid and small companies do not have pricing power and are forced to absorb higher costs thereby lowering their profitability and ultimately their valuations. Auto ancillary industry provides the best example. Between 2004 and 2007 companies consistently failed to get timely price increases in spite of higher raw material (commodity) prices. Instances of branded consumer goods companies deferring price hikes also abound. Penultimate transmission of these prices to the consumers is painful for companies as well as investors   

Government’s fiscal profligacy is driven by larger political considerations. Welfare spending and subsidies play a key role in driving inflation. Many schemes increase labour costs without corresponding increases in supply or productivity gains leading to further reduction in competitiveness. Reduced mobility of labour creates further imbalances.

Currency depreciation seems to be a blameless way of balancing the situation. A lay person does not understand implications of exchange rate declines, making it easier for the polity to escape the blame.

In today’s context a larger dose of competitiveness could be infused through lower real estate prices than currency devaluation. The benefit of lower real estate prices would be felt across the economy and would boost sectors such as organised retail and create new jobs.

Real estate developers and banks with exposures to developers would be negatively impacted in the near term. In a country chronically starved of housing stock, improved affordability would lead to improving volumes in the commercial segment first and eventually in the residential segment. Larger volumes would have a cascading effect on commodity producers such as cement and steel.

Other ancillary benefits for businesses resulting from being located near cities in the form of better quality man power and lower logistical costs are unquantifiable but would certainly contribute to better quality of life for a wider population.

Signing off

Sundeep Patel