Go long on the dollar, given rupee weakness

The market fell on Monday on the news that Macquarie Asia Hedge Fund was exiting the Indian derivatives market due to its anticipation of tax incidence in 2012-13. The exit triggered further selling by other traders due to fears that this exit would influence other foreign institutional investors (FIIs) to also cut their India exposure for similar tax-related reasons. If there is a reversal of FII inflows, the market will head lower.

Ironically, the hedge fund was net short on India and will continue to short the Indian market through Nifty derivatives on the Singapore Stock Exchange. This highlights the poor timing of proposed changes in the tax code. If the Indian stock market had been bullish, FIIs would have swallowed their resentment, paid taxes and continued to invest.

During a bear market, most FIIs will simply cut Indian exposures. Some of the hedge funds that are prepared to go short will find ways to take exposures in derivatives traded in Singapore and Dubai or by selling Indian ADRs.

Of course, any trend of FII selling increases downward pressure on the rupee. Any trend-watcher will have noted a succession of three-month rupee lows versus the dollar over the past couple of weeks. Most trend following systems indicate a long dollar-rupee remains a good trade, with every likelihood of a further fall in the rupee. There’s a fair chance it will surpass the all-time lows of Rs 54 plus within Q1 FY13, given a wider trade gap.

In turn, that has several more implications. One is the obvious pressure on Indian companies that possess ECB/FCCB exposures and also net importers. Another is the potential upside for exporters, who will gain in both price competitiveness and also see higher rupee bottom lines, as their aboard profits are boosted by the favourable exchange rate.

The party-pooper could be the Reserve Bank of India (RBI), of course. At some point, if the rupee starts going south at speed, the central bank is likely to intervene. When it does, there will be a sharp pullback. However, RBI is unlikely to intervene with a great deal of vigour or conviction because it has some genuine worries on the reserves front. It would probably prefer to preserve its war chest and allow a gradual depreciation, rather than risk a full-scale run on the rupee. The RBI’s doctrine of the “dirty float” is based on a concept of a dollar-rupee band within which it doesn’t intervene. In the past 12 months, this band has gradually been adjusted down. In November-December 2011, RBI intervened at the Rs 53-54 level. Chances are, this time around, it would let the currency drift a little lower.

The author is a technical and equity analyst