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“THE EFFECT OF RUPEE DEPRECIATION ON INDIAN ECONOMY”

Submitted to

MUMBAI UNIVERSITY

FOR THE PARTIAL FULFILLMEN T OF THE DEGREE OF

Masters of Comme rce

ECONOMICS

SESSION 2013-2014

DEPT. OF MANAGEMEN T STUDIES

MULUND COLLEGE OF COMMERCE

Under the guidance of: MR. PAWAR

Submitted by: RAVEENA UDASI

Roll: - 15051

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DECLARATION

I, Raveena Udasi, student of MCom here by declared that the research

report entit led “SUCCESS AND FAILURES OF EUROPEAN UNION” is

comple ted and submitted under the guidance of is my origina l work.

The imper ia l find ing in this report is based on the data collec ted by me. I have

not submitted this project report to any other Unive rs ity for the purpose of

compliance of any requirement of any examina tion or degree.

DATE: Raveena Udasi

M.Com Sem I

ROLL NO. 15051

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CERTIFICATE

I, Prof. Pawar, hereby certify that Miss Raveena Manoj Udasi ROLL. No 15051 of Mulund

College of Commerce, S. N. Road, Mulund (West), Mumbai -400080 of M.com Part I (Business

Management) has completed her project on “The effect of Rupee depreciation on Indian

Economy” during the academic year 2013-14. The information submitted is true and original to

the best of my knowledge.

____________________ ___________________

Project Guide Principal

_____________________ ___________________

Co-coordinator External guide

Date:

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ACKNOWLEDGEM EN TS

A research project is a golden

opportunity for learning and self development. I conside r myse lf very lucky and honored to have so many wonderful people lead me through in comple t ion of

this project.

My grate ful thanks to Mr. Pawar who in spite of being extraord ina r i ly busy with her/his duties , took time out to

hear, guide and keep me on the correct path. I do not know where I would have been without her/him. A humble ‘Thank you’ Sir.

I would also like to thank everyone who took active invo lvement in help ing me with my project report withou t whom, it would not have been possib le.

RAVEENA UDASI

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EXECUTIVE SUMMARY

Deprecia t ion refers to a fall in the value of the domestic currency which is

caused by the demand for foreign currency exceeding its supply in the market. In such a situa t ion one has to pay more than before to get units of foreign

currency. This fall takes place in the market and on its own. Market determined exchange rate serves the purpose of align ing the domestic economy with the world economy was the price route. As consequence s the domestic price gets

linked up with those of the world price. With the libera l izat ions and globa lizat ion of the economy in recent years, imports are bound to increase. The

lessening of restrict ions on imports and lowering of tariff on imports which the economic reform imp lies, an increase in imports has in fact taken place. Again with trade having become an importan t element of the new strategy of growth.

India being a develop ing economy with high inflat ion, depreciat ion of the

currency is quite natura l. Depreciat ion of rupee is good, so long as it is not volat ile. A random depreciat ion that we have seen in the last few months is bad and it has hurt the economy. Right from the beginning of year 2013, the value of

rupee has been deprecia t ing.

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TABLE OF CONTENT

SR. NO. TABLE OF CONTENTS

PG. NO.

1 INTRODUCTION 8

2 IMPACT OF RUPEE DEPRECIATION 14

3 ROLE OF RBI 16

4 NEGATIVE FEEDBACK MECHANISM 20

5 IMPOSSIBLE TRINITY 22

6 CAUSES OF THE DEPRECIATION 23

7 BAD NEWS / GOOD NEWS 25

8 ROLE OF THE GOVERNMEN T 26

9 CONCLUSIONS 30

10 RESEARC H DATA TABULATION & ANALYSIS 40

11 FINDINGS AND RECOMMENDATIONS 41

12 BIBLIOGRAP HY 42

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LIMITATION OF RESEARCH

Of all the living things in this world, Human Beings are the most unpred ic tab le

and sometimes may act in a most irrat iona l manner. Hence the research should not be conside red to have a unive rsa l applicat ion since a conside rab le degree of behavio ra l aspect is invo lved in making investment decisions.

The research is also a bit narrow in scope as it considers only the success and

failures of European Nation. It did not take into account a very important factor which is traveling to the European countr ies for data evalua t ion and find ings but limits to the data provided in the books and compute rs. However, the detailed

study with the same approach can be performed .

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INTRODUCTION RUPEE DEPRECIATION

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“We invented money and we use it, yet we cannot understand its laws or control

its actions. It has a life of its own.” - Lione l Trill ing, American lite ra ry critic.

The most concerning chapter for India during last two years and specifica l ly last two months is the weakening of rupee agains t dollar . It is not only that rupee

has lost its value in the globa l context but also dolla r has improved its performance in the globa l trading markets. The outstand ing performance of US equit ies and the improvement in the labor market has made America ns more

optimis t ic about the US economy, thereby stimula t ing greater hopes of QE(Quanti ta t ive Easing) tapering.

The government of India is still unab le to generate heavy capita l inflows. I f US

Federal Reserve withd raws its bond buying programme; there will be unexpec ted outward flow of money leaving India clambering for dolla rs . The slowdown in the Indian economy has made the situa t ion more fick le.

The government has a strong role in contro ll ing currency in the form of policy

regula t ion and reforms. The current UPA leadership has failed to strike with some heavy reform to generate more cash inflows . As a result the government

has gradua lly lost its control over rupee deprecia t ion. Inves to rs’ sentiment plays a pivota l role over here.

Oil and gold imports account for 35 per cent and 11 per cent of India ’s trade bill

respective ly.There has been an uninterrupted demand for the dollar from the oil importe rs pushing the rupee lower. Likewise the falling gold prices have made the centra l bank to reduce imports, which increases CAD and hits the currency

direct ly. Indian economy requires a strong structura l reform to mainta in a posit ive balance of payment.

Also, government spends excess ive ly as elect ion approaches just to woo

electora te votes. Thiscauses the rupee to depreciate. Then the government beats around the bush to contro l the currency behaviour. Most of the times these measures worsen the economic crisis to a great extent.

The foreign inst itut iona l inves to rs have been selling index futures and Indian

equity market is weakening. As a result there is a heavy demand for dollar and Indian currency as well as economic situa t ion is looking too gloomy.

These worrie s, combined with a record high current account defic it and now

uncerta inty over the centra l bank’s moneta ry policy stance, have prompted foreign inves to rs to sell more than $12 billion of Indian debt and equit ie s since

late May.

Reserve Bank of India has taken certain steps and some more to be followed to have a control over rupee. But the big question comes here.

what are the implica t ions?

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The best business prototype anyone can have is to spend in rupees and earn in dollars, which is what the giants of India Inc, includ ing the top IT companies,

excel in. Basica lly the sector which is target ing exports for its industr ia l operations are the one wins the game.

Dolla r apprecia t ion would be positive for sectors such as IT, pharmaceutica ls , hotel, textiles and automob iles which have the total foreign exchange earnings of these firms are far greater than their forex spends. As much as the rupee

weakens, the foreign exchange earners gain provided the other factors remains constant.

A sharply declining rupee triggers infla t ion, broaden the current account defic it,

hits inves to r sentiment and creates burdens for organizat ion with high exposure to foreign debt. The government and the Reserve Bank of India have taken

severa l reform init ia t ives to resist the downturn, but their success stories are looking gloomy.

Buying imported mater ia ls will become very costly. A weak rupee will create extra stress on Oil Marketing Companies (OMC) and this will surely be passed

on to the consumers as the companies are allowed to do so after the deregula t ion of petrol and partia l deregula t ion of diesel. If the OMCs increase fuel prices,

there will be a substantia l increase in overall cost of transpor ta t ion which will trigge r infla t ion.

If the depreciat ion is steep and without control, it will strike up infla t ion. As a result the Central bank would have very less room to impose further rate cut and

that’s the burden the borrower would have to bear.

Indians who have gone to abroad for tours or studies are highly affec ted in these times . The only smiling people in this context are the NRI’s who gain more on

sending money to their home land.

As a whole we can say that though weakening rupee is the reason for someone’s smile it is a real threat for the country’s overall fisca l health and increase the

current account defic i t heavily. But in my opinion this huge downgrade is a temporary phenomenon and the rupee is really oversold. Now the Central bank and Government should work hand in hand and find out the policy measures to

stabilize the frightening scenario. I persona lly hope a further cut in SLR to ease the liquid i ty to save rupee and also import duty hike in gold and other related

mater ia ls. RBI can buy bonds to ease liquid ity in the market. Fina lly we can say that the situat ion is tight and challenging for us, but we can not only hope for the best but also should contribute the most to get back Indian economy in the

driving seat.

With the rupee shedding over 10 per cent in value since the last week of July, there is a lot of attent ion on the volat i le nature of the Indian Currency vis-a-vis

the US dolla r. But, the current free fall in the domestic currency to Rs 49-50 leve ls is in a way mirror ing a histo r ica l trend. Two major rupee devalua t ions occurred in 1966 and the early 90s. The reasons for the two devaluat ions were

not too dissimila r ; twin defic i t (current account and fisca l), soaring infla t ion,

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insuffic ient foreign exchange reserves, and the developed world demand ing decontro l and libera liza t ion to allow them to do business in India.

The reason for the fall

The Indian rupee is under great stress as overseas inves to rs are paring their exposure to Asia’s third- la rges t economy amid the US and Euro-zone crisis and

mounting worrie s over the domestic economy. The globa l uncerta inty and various economy crisis has forced the investors, large banks, investors and fi-

nancia l inst itut ions to search for safe haven and they have now started selling Euros and buying dollars. Thus, the dollar has apprecia ted agains t all major

currenc ies inc lud ing rupee. These inves to rs are quick ly pulling out the money from Indian market and invest ing in other safe investments such as Gold or the

US dolla r.

The 3 major factors contr ibuting to the fall are:

1. Risk Avers ion on part of Currency Investors, which has caused the Demand

for the US Dollar to go up world over.

2. Uncerta in Economic Situa t ion around the globe

3. FII’s turning Net-Selle`rs and withd rawing funds from the Indian Market.

Comparisons with a wider basket of 36 currenc ies also ind ica te that the rupee

has indeed appreciated by almost 15 per cent in real terms. Hence, purely from an analyt ica l perspect ive, the deprecia t ion in the rupee is an overdue market

adjustmen t, result ing from the nexus between exchange rate, infla t ion and interes t rates in the economy.

Impact of Rupee Deprecia t ion on the Indian Economy

Infla t ion graph and Fisca l defic it to scale up

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Currently, India is suffe r ing from a near two digit infla t ionary pressure . A deprecia t ing rupee would only add fuel to this. It would lead to high infla t ion,

as India imports around 70 per cent of its crude oil requirement and the government would have to pay more for it in rupee terms. Due to the control on

oil prices, the government may not easily pass the increased prices to the consumers . Furthe r, this higher import bill will lead to rise in fisca l defic it for

the government and will push the infla t ion.

On November 21 alone, overseas funds sold more than US$500 mill ion worth of

Indian- listed shares over the five trading sessions, reducing net inflows for 2011 to under US$300 mill ion. The rupee has lost more than 10 percent of its value this year, making it one of the worst performing currenc ies in Asia. In the light

of uncerta inty and fall in globa l stock market, FII’s are supposed to be pulling out their money from various EME’s (Emerging Market Economies) and taking

them back to their home countr ies in order to susta in themse lves.

A blow to Indian Importers

The Indian import indus try would also have to pay more in rupee terms for procur ing their raw mater ia ls. This would happen despite a drop in globa l

commod ity prices, only because of a depreciat ing rupee against dollar. Corporate India is a net borrower of dollars and to that extent a depreciat ing

rupee would impact its balance sheet adverse ly. Companies with foreign debt on their books would also be impac ted. With the rupee deprecia t ing against the

dollar , these companies would need more rupees to repay their loans in dollars. This will increase their debt burden and lower their profits. Obvious ly, inves tors would do better to stay away from companies with high foreign debt.

The deprecia t ing rupee has pushed up the prices of electron ic gadgets and home appliances. Car makers who import 10 to 40 percent of the components are

contemp lat ing increas ing prices. This is an attempt to offset the increased import costs owing to the deprecia t ing rupee. An increase in prices could span

from Rs 10,000 for small cars to Rs 50,000 for luxury vehic les . The rising interes t rates and fuel hikes have played spoilspo rt for the car indus try

that is brimming with a wide array of choice for consumers.

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IMPACT OF RUPEE DEPRECIATION

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Negative impact on Indian students and travellers abroad

Individua lly, travell ing abroad becomes more expens ive as travel cost could go up by around 10 per cent compared to last July figures. Students studying

abroad too will be hit as more rupees will go out to pay for the courses, stay and other expenses .

Impact on Oil Imports

Oil imports consume the larges t part of the FOREX reserves. A deprecia t ing rupee is bound to offset the decrease in the internat iona l prices of commod it ie s

such as oil. As can be seen from the figure below although the oil price per barrel has fallen however the depreciat ing rupee has not given any respite to the

importe r as they actually have to shell out more money in order to purchase the same quantity of oil. Take for instance crude oil imports. Brent crude oil price

was $118.46 per barrel on April 2011 when exchange rate for the rupee was Rs 44.4 to a dollar . On November, oil price had gone down to $109.03 per barrel

and exchange rate was Rs 52.7 to a dollar. Thus, because of the rupee deprecia t ion not much benefit can be derived out of the lower oil price. Instead, the increase in price of import ing oil between April and November is to the tune

of Rs. 489.8 per barrel.

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Cheerful news for Exporters

When a currency depreciates , the exporters make more profit because they get

more of the local currency for every unit of foreign currency though the quantity of trade remains unchanged. The deprecia t ing rupee would be posit ive for the

Indian IT sector which generates more than 85 per cent of their $70 billion revenue from the overseas markets. This kind of apprecia t ion in foreign

currency will enhance their actual realisat ion of revenue in dolla r terms.

Role of RBI

RBI will interfere in this area because a steady value of rupee is essentia l for

the orderly growth of the economy. A depreciat ing rupee will harm oilmarketing companies, and other import oriented businesses. This may help

the software companies and other exporters, who get their payment in dollars.

RBI will be watching the posit ion and interfe re to stabilize the currency value . In case of deprecia t ion, RBI will sell foreign currency from the reserve and this

will help in arrest ing the fall of rupee to some extent .

Possib le Solut ions

Oil import demand could be staggered and purchases co-ordina ted so that at no

point there is undue bundling of imports .

The government can take init ia t ives which encourage and increase the flow of

foreign inves tments into India. Three recent steps taken by the government be it the pension fund FDI limit or the increase in the inves tment limit inves tors in government security and corporate bonds are the steps in the right direct ion.

The government can make investments attract ive and invites long term FDI debt funds in infras tructure sector.

Government can conside r tempora ry import compress ion.

FDI in the aviat ion indus try retail can also attract foreign inves to rs.

Exchange Rate Mechanism

Let us first try to unders tand how exchange rate is determined? All economies

that interact with internat iona l economy can be broadly class ified into three

categor ies on the basis of exchange rate policy of the country.

1. Fixed Exchange Rate: These economies peg the value of their currency with

some other prominent currency like US dollar. This system is simp le and

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provides stability to the economy (of course, if the economy of the country to

whose currency its currency is pegged is stable) . This type of exchange rate

regime is mainta ined by genera l ly smalle r economies like Nepal and Bhutan

(pegged to Indian Rupee) or several African nations. Rationa l behind such

regime is that in case of small economy – if the exchange rate

ismarke t determined – the sudden influx or outflux of even relat ive ly small

amount offore ign capita l will have large impac t on exchange rate and cause

instab i l ity to its economy. Notable exception is China which despite being large

economy has its currency pegged to US dollar . But then when it comes to China ,

its irrat iona l to talk about rationa li ty .

2. Floating (or free) Exchange Rate: Bigger and developed economies like US,

UK, Japan etc genera lly let market determine their exchange rate. In such

economy exchange rate is determined by demand and supply of the currency.

For example consider exchange rate of US dollar versus Japanese Yen. If US

wants to import certain item from Japan, it will have to pay the Japanese

company in Japanese yen. This is because in common market of Japan, dolla r

will not fetch you anything. But the American company will not have Yen, so it

will purchase Yen from the interna t iona l currency market. This will increase the

demand of Yen and supply of dolla r. Thus the value of Yen vis a vis dollar will

increase. Similar ly if Japanese company is import ing something from US, it will

increase value of dolla r as compared to Yen.

Export- import, though the major, is not the only source for currency exchange.

Capita l flow – Americans inves t ing in Japan and Japanese inves t ing in USA – is

also a signif icant source of currency exchange . Anothe r source of currency

exchange is remittance – that is the money sent home by Americans working in

Japan and vice versa. Cumula t ive of all these exchanges determine the exchange

rate. If net requiremen t of Dolla r by Japanese is more than net Yen required by

USA, dollar will apprecia te agains t Yen. You should also unders tand that this is

oversimp lified for the purpose of illus tra t ion. In real world, there will be

mult ilate ra l interac t ions and fina l exchange rate will be equilibr ium reached by

all those interac t ions.

3. Hybrid system: Most mid sized economy like India practices a mix of both

these regimes. It allows for the exchange rate to float in a range which it deems

comfortab le. Once the market determined rate tries to breach this range, centra l

bank (government) intervenes in the currency market and contro ls the exchange

rate.

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How does governme nt control exchange rate?

In fixed or hybrid exchange rate regime where governmen t contro ls exchange

rate, contro l is exercised by active ly partic ipa t ing in interna t iona l currency

market through its centra l bank (Reserve Bank of India or RBI in our case).

Suppose there is huge demand of rupee in India which is driving the value of

rupee. Also, lets assume that RBI is comfortab le only in range of Rs 50 to Rs.

60 per US dolla r. This rapid surge in the demand of rupee (which might be

because a. Indian export is far more than its import, b. foreign investors want to

inves t in India and c. large number of Indians earning abroad are remit t ing their

money back home) is pushing the exchange rate below Rs. 50 per dollar. The

RBI will then step in the market and will offer Rs. 50 for each dollar. Those

buying rupees agains t dollar will now purchase from RBI since its offer ing

better rate. Soon other traders will have to arrive at this rate, if they want to

partic ipa te . Since RBI has the ability to print currency notes, it can keep the

lower limit of exchange rate fixed at this value. When demand for rupee is

subsided, RBI will step back and let market determine the exchange rate. In the

process, RBI will have accumulated a pool of dollars; this is called forex

reserve or foreign exchange reserve.

Now let us move to other extreme. Suppose Indian exports have dwind led ,

imports are on surge, foreign inves to rs are flee ing Indian market and

remit tances are at all time low. Now, every one wants dollar but there is litt le

supply. This will drive the price of dolla r up. Its about to breach the upper limit

of Rs. 60/ USD. RBI will step in again and will put its dollar reserves on sale at

the rate of Rs. 60/ USD. This will stop the further depreciat ion of rupee.

As you can see, in order to be able to stop the currency from apprecia t ing, RBI

will have to print money and for preventing its depreciat ion it needs a reserve of

dollar . This constra in t has interest ing imp licat ions on the current predicament of

RBI in the context of depreciat ing rupee.

Effec t of exchange rate on Import and Export : Suppose US company wants to

buy Indian textile and suppose on T-Shir t costs Rs. 120 and exchange rate is Rs.

50/$. So for american company the cost of T-Shir t is $2.4. Now, if rupee

deprecia tes to Rs. 60/$ the price of T-shir t becomes $2 only. This will make

Indian T-shir t cheaper to buy and will increase its demand. Companies who were

import ing from other nations (may be China or Bangladesh) might shift to India

and Indian exports will increase.

Consider the opposite scenar io. Rupee appreciates to Rs. 40/$ making the cost

of one T-shir t $3. This will repel US importers and might drive them to other

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riva l exporters whose garments are cheaper. Thus, depreciat ing currency helps

exports while apprecia t ing currency has opposite effect .

Similar ly if India imports $ 1000 iPad from US, at exchange rate of Rs. 60, it

will cost Rs. 60000. If currency apprecia tes to Rs. 50/$ the price will reduce by

Rs. 10000. This might encourage many new people to by iPad which earlier

thought it to be too expens ive. Thus, the demand for imported products will

increase in apprecia t ing currency and will drive imports upward. Deprecia t ing

currency will have opposite effect.

Balance of Payment (BoP) Accounts

Internat iona l monetary transact ions of a nation is recorded in two accounts .

1. Current Account: This records all the trades (export- import), remittances,

interes ts and earnings on inves tments made into out side countr ie s and other

flows which is current in nature (meaning with no intention of future return). If

total inflows in the country (its export, remit tances and earning from its

inves tmen ts abroad) is more than its outflows (its import, remit tances out of the

country, payments of interests etc.) then the country is said to have current

account surplus. China, owing to its huge exports, is currently the nation with

larges t current account surplus . Simila r ly, if outflows exceeds inflows, the

country is said to be in current account defic it . USA has the larges t current

account defic i t. India too has huge current account defic it (about 1 20 billion

USD in FY 2012)

2. Capita l Account: This records all the flow (into or out of the country) made

for future return – inves tment in stocks, bond or companies , in real estate or

FDI (inves tment made for setting up of business or indus try) . It also includes

loans taken from abroad (which actually is inves tment by foreign lender into the

nation). Foreign Currency Reserves are also part of Capita l account but are

genera lly not reported. A country is said to be in Capita l account surplus if total

inflows into the country (FII, FDI and borrowing from foreign companies /banks)

exceeds total outflows (inves tments into foreign countr ies and lend ing to

foreign countr ie s or companies) . In case situat ion is reversed, country has

capita l account defic it.

Payments always get balanced : You can spend only as much money as you have.

Or in other words, total amount you spend and inves t must always be equal to

the money you have earned and loans you have taken. What this means in the

context of BoP is that current account surplus must always be balanced by

Capita l account defic i t and if a country is having current account defic it, it must

always get equiva lent money form of capita l account surplus.

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BoP and Forex Reserves : Countr ie s having float ing exchange rate and free

capita l flows do not have to build foreign currency reserves. But as we have

seen earlier , those who exercise some or full contro l over exchange rate, do so

by manipula t ing their Forex Reserves. The difference in current account surplus

and capita l account (exclud ing forex reserves) defic it is balanced by equal

increase in forex reserves (China) and if country is not able to meet current

account defic i t by capita l flows, then it will have to liquida te its forex reserve

(current situat ion of India ).

For example, China which has huge exports (current account surplus) as well

has huge inflows in FDI and FII, balances this by build ing up huge forex

reserves as well as by inves t ing in foreign countr ies . Chinese government parks

large percentage of its surplus into US governmen t bonds and encourages its

government backed and other companies to buy assets in foreign countr ies

(mostly US). So it delibe ra te ly runs huge capita l account defic it so that it can

export. Otherwise , it will have to let its artific ia l ly depre ciated currency

apprecia te. This is interest ing and perhaps topic for another future artic le.

Negative Feedback Mechanism

Example of negative feedback system

Wikiped ia defines negative feedback as following “Negative feedback occurs

when the result of a process inf luences the operation of the process itself in

such a way as to reduce changes.” In order to understand this concept look at

the adjacent diagram (Again taken from Wikiped ia ). As you can see in the

diagram, when water leve l in the reservo ir decreases, the piston stopping water

flow is lifted and water starts to pour in. When water is filled, the piston will

again come down to stop more water from pouring and this will mainta in the

water at desired leve l. The equilib r ium leve l of water will be determined by the

arrangement of the system rather than the flow of water.

Similar negative feedback system exists in economics . For example, conside r

exchange rate and export- import. Actua l situa t ion will be very complica ted

because of a large number of variab le interac t ing togethe r. To keep things

simp le, we will conside r only two variab les at a time – export- import and

exchange rate. As we have discussed above, apprecia t ion

currency causes increase in import while discourages export. This will lead to

increase in demand for foreign currency and simultaneous ly increase in supply

of local currency. This putting a downward pressure on exchange rate. If

government does not interfe re and there is no net capita l flow, then exchange

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rate will quick ly adjust such that values of imports and exports are perfect ly

matched.

Relat ion between interes t rate and exchange rate (Interes t Rate Parity)

Anothe r beautiful example of such feedback system is interes t rate parity. In

order to expla in it lets assume Interes t rate for borrowing in USA is 4% and

interes t one gets on government bond in India is 8%. It will make perfect

business sense if you borrowed $1000 from USA, purchased Indian government

bond and after a year you got interest of $80. Paid $40 as interest to the bank

you borrowed from, and made a profit of $40. That withou t inves t ing a single

penny of your own. Such situa t ion where you can make money without inves t ing

any capita l at all is called arbitrage (which in itse lf is fascina t ing financ ia l

concept and deserves a comple te artic le on itself ).

The only problem with this is it will not be only you who can think of this.

Other people too would want to make profit out of this opportunity and soon

there will be many dollars flowing from USA to India causing Indian Rupe e to

apprecia te in comparison to USD and whatever gains you could make from

excess interes t rate will be offset by the increase in exchange rate.

Self fulf i ll ing prophec ies or Posit ive Feedback

Direct ly opposite to the concept of Negative feedback is Self Fulfil l ing

Prophec ies or Posit ive feedback. For example suppose there is a rumor,

comple te ly unfounded , that the price of gold is going to increase to very high in

a week. People will want to profit from this info rmation and will buy some gold

to sold later at higher price. Init ia l ly, some people will be fooled by the rumor

and buy gold. This tempora ry surge in short term demand will lead to

momenta ry increase in price. This increase in price will give credence to the

rumor, and more people will flock in to buy gold. This will further increase the

price, pulling even more people. The rumor, which originated without any

analys is or “fundamenta l” cause, was the reason itself for the rumor becoming

true.

Such positive feedback are very common in our life , enginee r ing and economics .

In context of exchange rate, sometimes positive feedback plays a prominen t

role. Suppose, all the traders in foreign exchange market believe that rupee has

deprecia ted far below its ‘intr ins ic’ value and it will apprecia te in near fu ture.

In order to profit from this antic ipa ted gain, they will try to hoard the rupee,

thus increas ing its demand and causing it to appreciate.

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Opposite of this is also true. If traders believe that rupee (or for that matter any

currency) is about to deprecia te , they might actually trigger it by shorting the

currency.

The paradox of negative and posit ive feedback

What seems to be posit ive feedback in short term might actua lly be negative

feedback if looked broadly. For example, lets look at the currency example

again. The genera l belie f that currency has fallen far below its true value caused

it to apprecia te through posit ive feedback mechanism. But, at the same time it

also prevented currency to deprecia te furthe r and hence acted as negative

feedback.

Exis tence of negative and positive feedback loops give rise to severa l

interes t ing phenomena in economics and in other areas. But the artic le has

already surpassed 2600 words, so I can not give many examples. However , one

example very crucia l to our ongoin g discuss ion can not be omit ted. It is what

economis ts say Imposs ible Trinity .

Imposs ible Trinity

The concept of imposs ib le trinity states that a country (or an economy) can not

simultaneous ly have Fixed exchange rate, Free capita l flow and independen t

moneta ry policy (which roughly means contro l over interes t rate).

For example, suppose India pegs its currency to say Rs. 60/$ and intends to

mainta in free capita l flow. Now, if it sets interes t rate that is higher than that of

USA, then money will start flowing in from US to bank on this arbitrage

opportunity (as we discussed earlier ). So, in order to mainta in its exchange rate,

it will have to buy Dolla rs. But it will have a limit to how much it can buy.

Similar ly, if it sets interest rates lower than US, money will start flowing out.

To prevent rupee from falling, it will have to sell off its dollar reserve. But that

can last only till its reserves gets fully depleted. Thus government will have to

set interes t rate equal to that of US.

If you look closely, India, in recent times, has tried to achieve this imposs ib le

trinity to some extent. It kept currency underva lued , wanted foreign inves to rs to

come in, and had to increase interes t rate to contain infla t ion. What makes this

more ludic rous is that it was attempted when our premie r is a trained economis t!

Now let us look at the unpreceden ted devalua t ion of rupee more closely.

22

Causes

What is good for Economy is bad for Polit ic s : India’s trade balance is highly

unfavo rab le. What this means is India imports far more than it exports. In fact,

Indian export is only about 80% of its imports, a defic it of about $ 120 bn

(2011). This defic i t is large ly balanced by remit tances (which stood at $69 bn in

2012), FDIs and FIIs.

Economica lly it makes sense for India to let its currency apprecia te because it

will make imports cheaper and help reduce its trade imba lance. But,

apprecia t ing currency will have negative impac t on its exports. Now, India

mainly exports labor intens ive goods and services – Software services, polished

diamond , textile s, processed cashew nuts, leathe r goods. These sectors genera te

huge employment. Apprecia t ion of currency causes fall in the profitab i li ty in

these sectors, leading to many people loose their jobs. Looked from perspective

of polit ic ians, this is huge ly unpopula r.

Even though the overall gain from apprecia ted rupee is far more than the losses,

gains per individua l are small in magnitude and distributed over a large

populat ion ; whereas losses per ind ividua l is large and concentra ted in mino r ity

of the popula t ion. Such polic ie s are imposs ib le to pursue in a democracy like

India because those at loss will be far more vocal while people at gain will not

bother at all.

Under such polit ica l conside ra t ions, our government, a coalit ion of severa l

parties can not afford to be bold. So, in last 5 -6 years, driven by impress ive

economic growth of India, when foreign inves to rs flocked , there was upward

pressure on the rupee. Government was unwil l ing to let rupee apprecia te and

kept it artific ia l ly devalued. In the process it amassed huge foreign exchange

reserves (about $300bn). Where did the government bring this money from? It

simp ly printed the money!

Print ing of more money causes infla t ion, another polit ica l ly unpopula r thing.

So, in order to curb the money supply, government issued bonds under Market

Stabiliza t ion Scheme (MSS bonds). It did curb the infla t ion to some extent, b ut

when bond matures, governmen t has to pay the money along with the inte rest .

So, this scheme does not really curb infla t ion, it postpones it. When those bonds

matured, government made payments, again by print ing more money, as

government is running budget defic it and does not have income to pay. This

caused infla t ion which you might have noticed during recent times. How does

government curb infla t ion now? It increased interes t rate to reduce the supply of

money.

Increase in interes t rate caused a slowdown in growth. Also, globa l economic

slowdown reduced demand for India exports and exports fell too (about 30% in

23

last year). Import however , did not fall by that amount because Oil, the major

component of our imports, is essentia l commod ity. So the trade balance turned

more unfavo rab le. Also, looking at the slowing pace of growth new inves tor

abstained from inves t ing in India and older inves to r too started to get uneasy.

As they tried to pull back their money, it put downward pressure on rupee.

If foreign inves to r expects the currency of a country to fall, it will withdraw its

inves tmen ts because its inves tment value will fall with the currency. For

example suppose you inves ted $1000 at Rs.40/$. So your inves tment in India is

Rs. 40000. Tomorrow if rupee falls to Rs. 60/$ then value of your investment

has fallen to $667. Foreign inves to rs fearing further fall in rupee started to flee

Indian market and this put furthe r downward pressure on rupee (Posit ive

feedback). Government could interfe re , but owing to its huge budget defic i t, had

limited resources and rupee had a free fall. There is more to it, but the artic le

swelling like Dolla r.

Impact

Economists do not agree about impac t of nomina l exchange rate on real

economy. Many argue that Nomina l values do not have any impac t on real

economy while others claim that the effect nomina l variab les have on human

psycho logy and expectat ions of future does hamper real economy (applying

posit ive feedback, you can see how?).

Two very visib le impac ts are 1. increas ing oil pr ices and 2. India gaining

competit ive advantage in certain export. Why oil price is increas ing is quite

obvious. The later impac t needs some elaborat ion. What has made the

devalua t ion of rupee more problematic is globa l slowdown. Alterna t ive ly, it

might well be that this downfa l l was brought about by the globa l slowdown. But

in eithe r cases, the demand for goods and services in developed economy is

dwind ling. But demand in certain goods like textile will not be impacted that

much (people are not going to shun wearing cloths because of slowdown). Main

competito r of India in such sector is China. During the same period when Indian

rupee has been falling, salar ie s of labors in China has been on the rise. This had

made Indian export more favorab le.

Anothe r impac t, which may seem like silver lining in the dark cloud is that it

has forced government to bring certain economic reforms (FDI in retail and

other sectors) and has brought a near cris is like situa t ion which can force

unwil l ing governmen t to bring reforms (as it did in 90s).

24

In macroeconomics theory, when a country’s currency declines, its exporters should

soon get a boost as the lower currency makes their goods more competitive. By

that rule, India should be, right now, enjoying an export boom. Since the start of

May, the currency has dropped 23 percent, making it one of the world’s worst

performers. Sure enough, exports did go up in July, rising 11.6 percent year -on-

year, the best increase in more than 12 months.

Consumers worldwide shouldn’ t expect to see a surge in Made- in-India products in

the coming months , however. The July increase comes after a period of

weakness : India’s exports dropped 1.8 percent in the 2012 -13 fisca l year. And

while the currency has been steadily weakening for two years, the dec line of the

rupee hasn’t helped narrow India’s current- account defic it. Instead, the trade

gap has just gotten bigger , hitt ing 9 percent of gross domestic product in the

first quarter.

BAD NEWS:

One culpr it is rising prices inside India, with the consumer price index jump ing

9.6 percent in July. India’s high inflat ion undercuts the competit iveness gains

from depreciat ion. Any benefit [from the weak rupee] will be offse t by the fact

that there is a huge infla t ion problem in India, and the cost of manufac t ur ing is

very high forlocal companies .

The cost of India’s imports , which are domina ted by petroleum and gold, have

shot up, and the fall in the value of the rupee will push them higher still.Ris ing

costs of raw materialsa re making business challenging. A stronger and a stable

currency is always better for businesses .

25

For Indian exports to boom, local exporters need trading partners with healthy

economies . There aren’t many of those around, making an export - led recovery

difficult. India’s structura l problems also make it harder for local exporters to

cash in on the weak rupee.

The country’s manufac ture rs have suffe red from India’s sorry history of

under investing in ports, roads and other infras truc ture. The infras truc ture deficit,

lowers growth potential and discourages foreign direct investment.

In the corporate media there is widespread discuss ion of whether India could soon

confront a current account cris is akin to that in 1991, when India was forced to

seek an emergency bailout from the IMF.

In recent weeks foreigners have been selling Indian government debt and now

reported ly hold just 43 percent of a government limit of $30 billion. Nervous

overseas investors responded by pulling more than $11 billion dollars out of

Indian stocks and bonds.

Over the past severa l years, India has financed much of the current accounts

defic it through short- term debt. The total short term-debt due before March 31,

2014 now amounts to a stagger ing $172 billion. The payment of this debt will

consume over 62 percent of the foreign exchange reserves .

The timing is particula r ly tough for consumer companies that were counting on

India’s September- to- December holiday season to spur sales. India’s consumers ,

whose spending helped see the country through the global financial crisis in 2008,

are closing their walle ts, squeezing companies from carmakers to shampoo

selle rs .

Companies that import finished goods or raw mater ia ls are the worst hit as they

scramb le to hold onto margins while balanc ing the need to raise prices without

deterring buyers.

India’s total consumption expend iture, which inc ludes private and government

spending, grew 3.3 percent in Jan-March 2013 from 9.3 percent in the same

period a year earlier , according to government estima tes. Tota l consumption

expend iture as a share of the country’s gross domestic product fell to 65.9

percent in the fourth quarter of 2012/13 from 72.1 percent in the first quarter of

the same fiscal year. While many consumer companies have resorted to price hikes

to cope with the currency, long- te rm supplier contracts and hedging are help ing

some to bite the bulle t for now.

More fundamenta l ly, the crisis is rooted in a dramatic slowing in India’s

economic growth and its growing, massive dependence on inflows of foreign

capita l to meet its current account deficit. In the last fisca l year, which ended March

26

31, India recorded growth of 5 percent, the lowest in a decade, and far less than

the minimum 8 percent needed to prevent a rapid rise in unemployment.

The government won a victory on Aug. 26 with the lower house of Parliament

approving a plan to provide subsid ized grain to two- third s of India’s 1.2 billion

people. That might help Congress stay in power next year, but it also increases

concerns that the government is backtrack ing on promises to cut the budget

defic it .

Few Good News

Information techno logy outsourcers such as Tata Consultancy

Services and Infosys have grown, thanks to low-cost workers in Banga lo re and

other Indian citie s,

The government is aware of the structura l problems and wants to make large

inves tmen ts to improve infras tructure in a manufac tur ing “indus tr ia l corridor”

between Delhi and Mumbai.

Higher costs in China , meanwhile, are leading some labor- intens ive

manufac turers to look for alternat ives in Asia, creating an opportunity for

India, To take advantage of the opening, India needs to revise rules that make it

difficul t for large employers to hire and fire workers.

Role of Governme nt

Over the past three months as the rupee has deprecia ted , the government has

announced a series of measures aimed at attract ing foreign capita l— inc lud ing

removing or lowering foreign inves tment caps and furthe r reducing government

spending at the expense of working people. But these have failed to arrest the

rupee’s slide.

Role of RBI

India’s centra l bank, the Reserve Bank of India, mounted a major intervention in

foreign exchange markets after the India rupee—which has depreciated by more

than 15 percent since May—crashed through more than 60 rupee per US dolla r

mark.

Sections of corporate India have been pressing for the Reserve Bank of India

(RBI) to abandon its reputed preoccupation with curbing infla t ion, which at the

retail leve l is currently close to 10 percent, and lower interest rates so as to

stimula te economic growth.

Instead, to stop the rupee’s slide, the RBI has tightened liquid i ty, thereby

driving up the cost of credit and furthe r undercutt ing economic growth, and has

27

sold off dolla rs , drawing down its foreign exchange reserves to about $277

billio n.

In a furthe r attemp t to stem the rupee’s slide and the deplet ion of its foreign

currency reserves especia l ly US dollars , the RBI imposed capita l contro ls on

Augus t 14. Hencefo r th Indian corporat ions— with the notable exception of large

government-owned enterpr ises or PSUs (Public Sector Units) —will not be

allowed to inves t more than 100 percent of their net worth (assets minus

liab il it ies ) outside the country in any year; individua ls will be restricted to a

maximum of $75,000. Prior to this, the annua l ce ilings were 400 percent and

$200,000 respective ly. The import of gold coins, which the government claims

has contributed to the current crisis, has been banned.

RBI vs .Governme nt

The crisis enve lop ing the Indian economy has caused increas ing frict ion

between the Congress- led Indian government and the RBI. While the former has

repeated ly made known its preference for interes t rate cuts aimed at boosting

growth, the RBI has resisted , arguing that infla t ion needs to be contained and

that a further erosion of the rupee’s value, will, by driving up energy

costs(Ind ia ’s imports three-quar te rs of its petroleum)severe ly dampen growth.

Also, it is acutely aware of the large foreign borrowing s India’s corporate giants

have contracted, seeking to take advantage of the much lower interes t rates that

have prevailed in the U.S. and Europe since 2008.

The conflic t between the RBI and the government reflec ts the fact the Indian

economy is now caught between a proverb ia l rock and a hard-place , with the

Indian elite facing a choice between trying to boost economic growth by letting

the rupee slide still furthe r, thereby fueling growth- sapp ing infla t ion or

defend ing the rupee by tighten ing credit and thereby further squeezing economic

growth. And in the background looms the threat of a rapid deplet ion of India’s

reserves as foreign capita l spurns a crisis- r idden economy

28

Lacking Confide nce

BNP Paribas slashed its economic growth forecast for India for the fisca l year

to March 2014 to 3.7 percent from its previous 5.2 percent – the weakest growth

since 1991-92 when India buckled under a balance of payments crisis that

required a loan from the Internat iona l Monetary Fund.

“Ind ia ’s parliament remains toxica l ly dysfunc tiona l with litt le, if

any, businessconduc ted , ” BNP said.

The rupee has plunged more than 20 percent this year, by far the bigges t

decliner among the Asian currenc ies tracked by Reuters.

Yet the government has so far failed to provide a coherent response, analys ts

said. Its approva l of infras truc ture projects was trumped by concerns about the

fisca l defic it after India’s lower house of parliament approved in Augus t a 1.35

trill ion rupees plan to provide cheap gain to the poor.

In its latest init ia t ive , the governmen t proposed setting up a task force to look

into currency swap agreements , a measure analys ts said could bring some relie f

if carried out in time by reducing market demand for dollars or other major

currenc ies.

29

Conclus ion:

Though growth has slowed down in recent times, the fundamenta ls of our

economy remains strong. Steps are being taken to contain the fisca l defic i t and

boost indus tr ia l inves tments.

Farmers in selected cluste rs adopted good agricu l tura l practices and benefited

from the yield advantage of hybr id rice techno logy. Impact of good monsoon

will gradua lly put impetus for growth and consumption primari ly from rural

India. It will also help in reducing infla t ion as surplus food production will help

reduce price, assuming that rupee bounces back and stabilizes in near future.

Growth in exports should also pick up as other major economies revive growth

and a feeble rupee will be able to fetch dollars which in return will translate

into more rupees. Also, a comparat ive ly weak rupee will make Indian produce

more competit ive in globa l markets and this by itself should, over time , help to

reduce imports and increase exports.

Limite d Impact For Most: A sustained rupee deprecia t ion is unlike ly to have a

negative impac t on the credit ratings for most inves tment- grade issuers that come under the Fitch Ratings Indian Nationa l scale. Two hundred and seventy-

four (accounting for over 92% of outstand ing debt) of 302 public ly rated issuers are unlike ly to face a negative rating action should the rupee trade between INR55/USD1 to INR60/USD1.

Some Negative Actions; Defaults Unlike ly : The remain ing 28 issue rs may expect negative rating actions, such as a change in Outlook or downgrade of the

30

rating, in the event of susta ined rupee deprecia t ion. Fitch does not expect any of these issuers to default .

Benefit For Exporte rs Capped: The posit ive impact on operating margins and leverage for export-or iented companies, which typica lly benefit from currency deprecia t ion, is expected to be lower than histor ica l ly observed. Fitch expects

that lower demand in the globa l economy, aggress ive price renegotia t ions, hedging of foreign-currency exposures and the negative impact of foreign -

currency debt servic ing will act to cap the benefit to credit profile s of companies in the pharmaceutica l, techno logy, text ile, and mining sectors

Higher Prices Passed On: Some importe rs are able to pass on higher prices from depreciat ion because of import parity price (IPP) practices prevale nt in

their industr ie s, such as companies in the oil and gas, or metals industry. Companies in the auto ancilla ry sector typica l ly have contracts to pass on higher

costs to their origina l equipment manufac ture rs . However, the slowdown in end -user demand may force companies in the auto ancillary sector to absorb some of the price increases.

Bearing the Brunt: Companies in the chemica l, fertil ise r or paper indus tr ies tend to import a signif icant portion of their raw mater ia ls, as do cement manufac turers without adequate domestic coal links. They are unlike ly to be

able to pass on higher costs because of current low demand, which will hurt margins. The credit profile for these sectors will be, on a relat ive basis, most

affected by rupee deprecia t ion.

No Direct Forex Exposure: There is no direct operationa l exposure to foreign currency for 121 issue rs (35% of overall debt). The potentia l benefit of reduction in globa l commod ity prices to margins for companies in sectors

includ ing real estate, metal processors, chemica l processors and print media will be offse t to a large extent by the rupee deprecia t ion.

Impact on Sub-Investme nt Grade: The potentia l posit ive operationa l impac t on

sub- inves tment grade companies is like ly to be more limited than that of correspond ing investment grade peers in indus tr ie s such as textiles, techno logy

and pharmaceutica ls .

Worst-Hit Sector: Sub-inves tment grade companies in the chemica l, meta l processing and trading (in processed and unprocessed imported commodit ie s )

indus tr ie s are expected to face lower margins, higher invento ry leve ls and stretched working capita l. They may be the worst casualt ies of the rupee deprecia t ion, particular ly if they have limited financ ia l flexib il i ty.

31

Appreciat ion Unlike ly: The rupee is unlike ly to apprecia te in the short term

until globa l risk avers ion subsides, according to Fitch.

The primary focus of this analys is is to evalua te the impac t of rupee

deprecia t ion on the credit profile of those inves tment grade companies with direct exposure to foreign exchange risk. The analys is evalua tes the stress that these issuers will experience if the rupee trades between INR55/USD1 to

INR60/USD1 for a sustained period of more than six months. Fitch notes that a temporary fall to say INR60/USD1 for a very short per iod is unlike ly to impa ir

the balance sheet strength of such inves tment- grade issuers.

Fitch analysed 302 issue rs that are public ly rated at investment grade („Fitch BBB- (ind)‟ and above) according to Fitch‟s nationa l scale. The total outstand ing adjusted debt (gross debt plus lease adjustment minus equity credit

for hybrid instruments plus preferred stock) for this group is INR8,639bn, of which about 25% is denomina ted in foreign currency, based on latest availab le

data.

Over 92% of the of overall adjusted debt is rated „Fitch A−(ind )‟ or above. Over 97% of the forex debt is with companies currently rated at „Fitch A - (ind )‟ or above. As such, these companies are expected to weather any significant

economic downtown.

Direct Forex Exposure

89% of foreign currency debt is held by net importe rs . However within the net importe rs‟ group, 90% of the foreign currency debt is held by just nine

companies . Of them the lowest rating is „Fitch A−(ind)‟ . Five of them are at „Fitch AAA(ind )‟ and three are at „Fitch AA(ind)‟. These issuers have

significant cushion availab le in their respective ratings and they are comfo rtab ly placed to weather any financ ia l stress on account of signif icant rupee deprecia t ion.

Impact on Debt

Sector-Wise Credit Impact

The section of report focuses on the impact of on credits from a rupee deprecia t ion on sectors where the impact (both posit ive and negative ) is pronounced. These sectors are not only core to the economy but also have

significant representat ion in Fitch‟s inves tment grade nationa l rating universe .

These sectors form four groups :

metals)

ys to mit iga te deprecia t ion (chemica l, paper, cement)

-dr iven exposure.

32

Net Exporte rs

This sector consists of either pure exporters (cotton textile, techno logy and

mining) or companies where exports are much higher than imports (synthe t ic

textile ,pharmaceutica ls and jewelle ry). Histor ica l data sugges ts that rupee

deprecia t ion may be an enabling factor but need not be a driving factor for

export growth.

Exports (in dollar terms) from India grew at rates higher than 20% (yoy) from

2003 to 2008. This period also coinc ided with histor ica l ly high globa l GDP growth levels (in excess of 4.8%) not observed since 1980 and correspond ingly

high globa l trade volumes. However over most of the period the rupee apprecia ted against the dollar.

Thus while rupee depreciat ion would have a posit ive impact on majority of

companies in these sectors, a fall in globa l demand from histor ica l leve ls may

significantly limit the degree of the posit ive impact . Addit iona lly, aggress ive

price negotia t ion from corporate clients of such exporters may potentia l ly

furthe r limit the benefits.

More established players in pharmaceutica ls and techno logy, which typica l ly

hedge in excess of 40% of their foreign currency exposure, may have a limited upside to credit profile s. Debt servic ing of foreign currency loans by a

significant number of pharmaceutica l and text ile companies is expected to limit improvement of credit profile s.

Pharmaceutica ls

Of the 11 pharmaceutica l companies rated inves tment grade, 10 are direct ly

exposed to foreign currency risk. In nine companies, the rupee depreciat ion is expected to have a posit ive impact .

The export data pertinent to this sector tend to sugges t that globa l demand has a

higher impac t on export volumes than the rupee exchange rate.

Techno logy

The impac t of forex deprecia t ion will be nomina l for four of 13 techno logy

companies rated by Fitch. Details of the remain ing nine are provided below:

Better-es tab l ished software companies tend to hedge a higher proportion of their forex exposure than relat ive ly smaller players . Those companies that expose a higher proportion of their cash flows to forex risk would temporar i ly enjoy

higher margins, though the long- te rm risk profile may not improve given the inherent higher volat il ity.

HCL Infosys tems Limited is the only company in this group which may have a

negative impac t on margins. The company imports significant proport ion of its components, while it has signif icant fixed cost contacts for systems integra t ion and computing. However, the company has been trying to convert dollar-

denomina ted purchases into rupee-denomina ted buying.

ITES segment has exhib i ted relat ive ly higher margin expans ion with respect to rupee depreciat ion than pure software players. The sector may benefit agains t

33

competito rs from countr ie s such as the Philipp ines whose currency has apprecia ted relat ive to the rupee (see Append ix 1).

Mining (Iron Ore)

Fitch‟s portfo lio of mining companies mainly comprises iron ore miners. These

companies derive about half of their revenues from exports. Of the six

companies in this sector, which are rated in inves tment grade, five are direct ly

impac ted by rupee deprecia t ion.

Textiles

The rupee depreciat ion would have a overall posit ive impact on the texit le

sector. However, the degree of positive impac t will be more limited than observed histor ica l ly given the muted demand in customer countr ies . Histor ica lly export volumes for segments such as cotton yarn/fab r ic and

synthe t ic yarn/fab r ic have benefit ted the most from rupee deprecia t ion. The export volumes of ready-made garments had limited benefit of rupee

deprecia t ion in the past. Incrementa l volume growth may not be expected, particula r ly in cotton textile (as it is relat ive ly less affordab le than synthe t ic s ) and ready-made garments.

Addit iona lly, the extent of margin benefit may be muted for more well

established players who tend to hedge substantia l portion of forex exposure. For

instance, Bhart iya Internat iona l Limited („Fitch A−(ind )‟ /S tab le‟ ) hedges up to

70% of its forex exposure . For Orient Fashions Exports Private Limited („Fitch

BBB−(ind) /S tab le‟ ), the forex gain has been negated by forward hedge posit ions

at a lower- than-p reva iling USD/INR exchange rate.

Gems and Jewellery

In Fitch‟s investment grade unive rse there are two co mpanies in the gems and

jewellery sector. Suashish Diamonds Limited („Fitch BBB‟/Stab le ) is an

exporter and would like ly be positive ly affected operationa lly. BC Sen &

Company Limited is a domestic jewelle ry retailer . Most gem and jewellery

exporters are expected to have a benefit operationa lly. However a lot of such

exporters were thus far genera t ing signif ican t „other income‟ because of the low

US dolla r Libor rate, a high domestic fixed-depos it rate and favourab le

dollar /rupee forward rates. This income was often 12% to 15% of the PBT of

such companies . However, this profit opportunity is like ly to diminish given the

reduction in domestic deposit rate and a rise in dollar /rupee forward rates. Thus

the observab le incrementa l benefit to margins (due to rup ee deprecia t ion) may

actually be negated in case of some companies .

Importe rs With Ways to Mitigate Depreciat ion

This group essentia l ly consis ts of indus tr ie s that are net importers. They are usually able to pass on cost hikes from the rupee deprecia t ion either due to IPP

34

norms followed in the industry (eg oil and gas, steel and non-ferrous metals) . However, there are sectors such as auto ancilla ry where the cost rise is passed

on to the origina l equipment manufacturer (OEM) as per contract .

Auto and Related

Of the 29 inves tment grade companies in this sector, for three companies the direct impact of foreign currenc y deprecia t ion will be ins ignif icant . The details

of 26 issue rs are provided below:

Fitch-ra ted auto supplie rs are like ly to remain large ly unaffec ted by current or

even sharper rupee deprecia t ion. Within this sector there is a subsector of

companies whic h would clearly benefit from export revenue ( assuming stable

demand in their export market) while the other subsector would consist of

companies that are net importe rs but would be able to pass through to the OEM

a significant portion of the price rise due to rupee depreciat ion.

Net exporters such as QH Talbros Limited , Ashok Leyland Ltd., Hi-Tech Gears Limited, Minda Corporat ion Limited and Beri Udyog Priva te Limited are

expected to be posit ive ly impac ted in terms of operating cash flow.

The second subcatego ry of companies has histo r ica l ly been able to pass on the cost rise to the OEM. However Fitch believes that the auto OEMs currently

experienc ing lower demand would be resistant to the past practise. Fitch believes that these price rises would be shared through the entire auto supply chain. Thus the benefits of rupee deprecia t ion on this sub -catego ry of auto

ancilla ry companies margin would be lower than would have been expected from histor ica l observat ions .

The auto and related sector has a relat ive ly higher proport ion of companies

having a hedging strategy. Within the 29 companies in this sector, 18 have a consis tent forex hedging strategy, where on an average 40% to 60% of the foreign currency exposure is hedged. This is expected to moderate the impac t of

rupee depreciat ion.

Negative impact on operating margins may be expected on companies inc lud ing Punch Ratna Fasteners Pvt Ltd, Sterling Tools Limited and Deltronix India,

which have significant imports. However, the rating headroom is suffic ient in most instances .

Fitch notes that the Indian subsid iar ies and joint ventures of globa l suppliers would be worst hit owing to very high dependence on parents for input mater ia ls

and componen ts. Emitec Emiss ion Control Techno logies Priva te Limited is one such example.

On a posit ive note, Fitch could see stepping up of effor ts to localise some of

these imported input mater ia ls as well as the componen ts by OEMs, which

would benefit the domestic auto suppliers in the medium term.

Oil and Gas

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The impac t of INR deprecia t ion on Fitch rated oil and gas companies can diffe r across public sector entit ies (PSE) such as IOC, HPCL and priva te refiners like

RIL and Essar Oil Ltd . Priva te refiners that import the bulk of their raw mater ia l could see their operating profitab i l ity fall in the range of 1% to 3% if

an exchange rate of INR55/USD persists. Exports for RIL (50%-60% of revenue) and Essar Oil (20%-40% of revenue ) can only provide limited mit iga t ion. Though these companies export a large part of their refined petroleum products,

the prices of many of these crude deriva t ive or petrochemica ls is determined by the demand-supp ly situa t ion of end-produc ts. This makes the pass- through of

high input prices difficu lt .

Forex borrowings for most of Fitch-ra ted oil and gas companies are low (0-20% for Essar, HPCL) to moderate (20%-50% for IOC, Petronet) except for Reliance, which has about 90% of its borrowing denominated in forex. Since public sector

enterpr ises are rated based on their strong linkages with government of Ind ia, Fitch does not expect their ratings to be impac ted by currency movements .

Reliance‟s credit metrics could be weakened because of its signif icant forex borrowings and the like ly impact of a rupee deprecia t ion on its operating profitab i l ity. However it is still like ly to remain very comfortab le for its rating

leve l.

On the contrary, the impac t of susta ined rupee depreciat ion on Essar Oil‟s operating profitab i l ity and financ ia l leverage – despite low forex borrowings –

could stretch its credit metr ic s beyond the agency‟s comfort leve l.

Metals

Globa lly, the price has fallen for ferrous and key non-ferrous meta ls over the

last 12 months (steel about 14%, aluminium 25%, copper 19%). However , due to

IPP and rupee deprecia t ion the prices in Indian market have remained broadly

unchanged from leve ls seen a year ago. Thus operating margins of Indian meta l

producers are expected to get substantia l support from the rupee d eprecia t ion

agains t globa l fall in metal prices. The extent of a benefit would depend on

degree of backward integra t ion (with respect to ore mines and links to coal

mines), with more integra ted players like ly to receive a higher benefit . This

indus try has high dependence on imported coal/coke, and would be to the same

extent, adverse ly affec ted by rupee depreciat ion.

Ferrous - Primary Steel Producers

Among Fitch rated Primary Steel producers Tata Steel Ltd (TSL) and Steel

Author i ty of India Ltd (SAIL), which have relat ive ly higher levels of vertica l

integra t ion, are expected to receive more cushion from the rupee deprecia t ion

agains t a fall in margins. However, players with limited or no vertica l

integra t ion (such as RINL) would be more adverse ly affec ted. Not only do these

companies have to import coke but the iron ore from domestic market would be

more expens ive by 10%, given the hike of iron ore by NMDC Ltd, India's larges t

iron ore miner .

36

Fitch believes the ability of steel producers to increase prices is limited because of the current weak end-user demand. Foreign currency loans will also result in

higher financ ing charges and lower net profits. However in most cases the rating is unlike ly to be affected given the suffic ien t rating headroom. The exception is

BPSL. Its export business is expected to have a positive impac t on margin. However BPSL has low rating headroom given its exist ing high leverage on account of its capacity expans ion.

Alloy/Spec ia lty Steel and Steel Products

Alloy/spec ia l ity steel producers using electr ic arc furnace for steel making are

large ly dependent on steel scrap (mostly imported ) for their operations. Globa l

scrap prices have softened by 6% as of end-May 2012 (from end-March 2012) as

agains t a steeper fall of 10% in the USD/INR rate during the same period. Such

companies usually enjoy some sourcing flexib i l ity as scrap iron may (to an

extent) be replaced by sponge iron. However, their sourcing flexib i l i ty may be

limited because of the disruption in operations of many small sp onge iron

companies located around Karnataka and Goa due to problems relating to iron

ore mining.

Indirec t Impact of Rupee Depreciation

These are companies that would essentia l ly be purchase rs of commod it ies linked to IPP. Their business models are comparab le to net importe rs to the extent that the infla ted cost (due to rupee deprecia t ion) of their raw materia ls would not be

easily passed onto the customer. These are sectors such as real estate (steel and cement comprise close to half of construc t ion cost), print media (newsprin t and

Pulp), and meta l (both ferrous and non-fe rrous) processors. While the globa l reduction in commod ity prices would have actually benefit ted their cost structure and may have boosted demand, the more than commensura te rupee

deprecia t ion has snatched away the advantage .

Impact on Sub-Investme nt Grade Issuers

Sub- inves tment grade companies are always more vulne rab le to business cycles. The direct iona l impact on operating margins may be comparab le to the sectors

in which they belong. Thus textile, pharmaceutica l and techno logy companies are like ly to make an opportunis t ic gain due to their unhedged posit ion. However they are more like ly to face drastic price renegotia t ions from their

customers.

Companies in sectors such as chemica l and metal processing are more like ly to absorb significant price rises (due to depreciat ion, which would affec t their

margins and signif icantly stress their credit profile ). The impac t on traders of processed and unprocessed commodit ies (meta ls , chemica ls , papers, rubbers) is

expected to be similar ly stressed. In each of these cases, the higher cost of invento ry, along with a possible increase in the working capita l cycle, could stress their liquid ity positions in the absence of suitab le fund ing options.

What May Change the Projecte d Outcome

37

Most of the trigge rs - - both positive and negative - - in the short term (defined as the next 12 months) are factors externa l to India. Maintenance of the rupee at

around INR55/USD1 to IBR57/US D may depend on a relat ive ly orderly resolut ion of the euro crisis ( to moderate flight to dollar -asset), a smooth

rebalanc ing of China‟s growth (to prevent furthe r deteriora t ion of sentiment towards emerging markets) and avoid ing geopolit ica l flare - ups (to prevent a spike in oil prices) . An adverse change in any of these factors may furthe r

deprecia te the rupee. This, would, however , feed into the deteriora t ing domestic balance of payments situa t ion and aggrava te it furthe r.

Given negative real interes t rates and the pressure on the exchange range,

extremely limited scope remains for moneta ry policy to correct the situa t ion. Similar ly, fisca l tools have limited scope without further affect ing the sovereign credit profile, given the high domestic fisca l defic it. Furthermore , should

inadequa te rainfa l l affec t agricul tura l output, the government may be expected to provide a stimulus to the sector as has been observed histor ica l ly. This may

aggrava te the fisca l deterio ra t ion.

Domestic policy-d r iven solut ions to address structura l issues (such as

deregula t ion of various subsid ies ) may improve investor sentiment. But these

benefits take time and the immed ia te impac t is like ly to be a higher infla t ion or

furthe r demand destruc t ion.

An analys is was performed on a group of 18 countr ie s rep resenting prominent emerging nations or countr ies that compete with India on a specific export -

oriented sector (such as textile s from Bangladesh). The countr ies whose local currenc ies deprecia ted the most agains t dollar as a group have the highest current account balance as a proportion of respective GDP. However, there are

exceptions. Examples include Mongo lia (ranked 18th, worst CAB/GDP ) and Chile (ranked 12th), whose currenc ies have depreciated less than 10% agains t

USD.

If the countr ies are ranked in terms of deteriorat ion in CAB/GDP ratio from 2011 to 2012, then the ranking sugges ts that some of the countr ies that have shown the worst deterio ra t ion are also countr ie s (Mongo lia, Chile) that have

deprecia ted the least agains t dollar . (In fact some have apprecia ted , such as the Philipp ines and China.)

Among these paramete rs (particula r ly CAB and government fisca l defic i t

related ), on an aggrega ted basis, India along with Sri Lanka, Mongolia , South Africa and Turkey have the worst deteriora t ion. The direct ion of the movement

of local currenc ies agains t the US dolla r may be driven by the fundamen ta ls . However, this fully does not expla in the huge deprecia t ion on the domestic currency value against the dollar.

For instance, Brazil (whose currency deprecia ted the most agains t the dollar),

may be comparab le with Mexico , Mongo lia, Vietnam Argentina and Chile on the basis of relat ive deterio ra t ion of these select macroeconomic paramete rs .

However, each of these five countr ies has local currenc ies that have shown relat ive ly much lower depreciat ion.

38

Impact of Globa l Risk Avers ion

Some of the countr ie s (Brazil , India, South Africa ) whose currency have

deprecia ted the most in the last 12 months are tracked in Figure 29. These

countr ie s, along with China and Russia , have been among the highes t

benefic iar ies of capita l inflows in emerging nations during the period of 2004 to

2008. Risk aversion may have reversed a signif icant portion of such capita l

flows .

39

RESEARCH DATA TABULATION & ANALYS IS

Descript ive research: The research will provide data about the "who, what, when, where and how" of a situa t ion, not what caused it. Therefore, descrip t ive

research is used for a project.

Research Design calls for decisions on the Data sources, Research approaches , Research instruments, Sampling plan and Contact method .

Data Sources:

1>Primary Data: Questions, Persona l interv iew (Sample size of few), Conference conducted by reporters for research work.

2>Secondary Data: Data from the Social Media, Interne t, Books and few European delega tes on a visit to India.

Research Approaches:

1>Survey Research: Survey’s would be conducted to find out the information

about the life sty le and importa nce of European Union. 2>Behavio ra l Data: Behavio ra l Data can also be used by going through the

databases (if availab le ) of the financ ia l Inst itu t ions and Banks and find ing out the economic state of the European Union.

3>Exper imenta l Research: Experiment Research may be used to unders tand cause and effect relat ionship between two objective variab les.

Research Instrume nt

1>Questionna ire : Questionna ire will contain both open ended and closed ended questions .

2>Psycho logica l tools : Psycho log ica l tools such as ladder ing technique, depth interview

40

FINDINGS AND CONCLUSIONS

The rupee’s decline affects everyone in the economy because it feeds direct ly

and ind irec t ly into genera l infla t ion, which is a continu in g problem even as

output growth decelera tes, and therefo re hits common people hard. There are

severa l ways in which the falling rupee immed ia te ly has an infla t ionary impac t ,

one of the most important of which is the price of energy. Since the misguided

decontro l of oil prices, it is not only the globa lly traded price of fuel but also

the exchange rate that determines domestic oil prices. Going by the way the

economies in the euro zone and the US have been behaving, it would be naïve to

expect that the export earnings would be contr ibuting significantly to foreign

exchange inflows in the near future. The govt should concentra te

On correcting the economic fundamenta ls rather than indulge in soap operas in a

run up to the elect ion. A better co-ordina t ion with RBI is required rather than

blame game.

Apart from all the polit ica l parties should come togethe r in fixing the problem

and gett ing back the inves to rs confidence.

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BIBLIOGRAPHY

http:/ /www.academia.edu/4169109 /F ac to rs_a ffect ing_ the_ f luc tua t ions_ in_excha

nge_rate_o f_ the_ Ind ian_Rupee_Group_9_C2

http:/ / ind ia ra t ings .co . in /up load /resea rch/spec ia lReports/2012/7 /3 /fi tch03Rupee.pdf

http:/ / ileadko lkata.wordpress. com/2013 /11 /08 /rupee -deprec ia t ion-and- i ts-impac t/

http:/ /www. ind ias ta t. com/a rt ic le /59 /nik hil/ ful l%20 text .pd f

http:/ /www.the leg is t. ne t / li fea f/2012-05-19-12-44-16 /f inance /55-rupee-deprecia t ion

http:/ /www. ii tk .ac . in/ ime /MBA_IITK/avantgarde /?p=1203

http:/ /www.cac lub ind ia. com/a r t ic le s/rupee-dep rec ia t ion- and- its- impac t-on-economy-an-overview-17954.asp#.UuDDj9K6bIU

http:/ /omegagoons. com/2013 /08 /deva lua t io n-o f-rupee- its-causes- impact- and-remedy/