In tandem: Steady depreciation in rupee spells trouble for stock prices

A steady depreciation in the rupee spells trouble for the rally on D-Street. Historically, most rallies in the equity market have occurred either when the rupee has appreciated or has been stable. In contrast, a decline in the value of the rupee against the dollar has been accompanied by market decline.

For example, the BSE Sensex is down around 2.6 per cent since the beginning of November, against a similar 1.9 per cent fall in the value of the rupee against the dollar in the period.

On Wednesday, the equity market and the rupee ended in red. The Indian currency closed on Wednesday at around 76.23 to a dollar, down around 0.47 per cent, from Rs 75.87 on Tuesday. In comparison, the BSE Sensex was down 0.57 per cent on Wednesday.

Similarly, the big rally on D-Street between April 2020 and September this year was accompanied by an appreciation in the rupee. While the benchmark index doubled during the period, the rupee appreciated by around 5 per cent during the period, from a low of around Rs 77 to a dollar in April 2020. (See the adjoining chart).

In the past two decades, there has been a negative 0.813 correlation between the value of the BSE Sensex and the rupee-dollar exchange rate.

Analysts attribute the negative relation between the value of the rupee and the stock market to the investing behaviour of foreign portfolio investors (FPIs).

“If FPIs believe the Indian currency will depreciate, they will slow their equity purchases or even sell their equity holdings in India. This results in a market decline or volatility,” says Shailendra Kumar, chief investment officer, Narnolia Securities. 

This shows up in the recent FPI activity in the equity market. While the rupee has depreciated by around 0.93 per cent in December so far, FPIs have been net sellers to tune of $2.84 billion in the equity market in the first fortnight of the same month.

Analysts say a currency depreciation creates an inflationary overhang in the economy, depressing equity valuation. “The historical data suggests a depreciation in the rupee is accompanied by a decline in equity valuation, translating into poor returns for investors. In contrast, when the rupee appreciates, valuation expands, leading to higher stock prices,” says Dhananjay Sinha, managing director and chief strategist, JM Financial Institutional Securities.

He expects the rupee to decline further to around Rs 77/78 to a dollar over the next 12 months. That, says Sinha, is likely to weigh on Indian equity markets.

The depreciation in the rupee is likely to be driven by a rise in India’s current account deficit (CAD) and a tightening of global liquidity due to monetary tapering by the US Federal Reserve (US Fed).

“The appreciation in the rupee from the April 2020 lows was underpinned by a decline in CAD due to record-low crude oil prices and strong capital flows after the quantitative easing by the US Fed. Both these tailwinds are now reversing, keeping the rupee under pressure,” says Sinha. 

India’s merchandise trade deficit has exceeded $20 billion in the past three months, including a record high of around $23 billion in November. This, say analysts, will result in a sharp rise in CAD in 2021-22.