Equities give positive returns after currency decline halts

On all 3 occasions when rupee fell sharply, markets gave double-digit returns over 3 months after the fall stopped

There seems to be too much pessimism in the air. While the risks - currency depreciation, falling dollar reserves, rising inflation and uncomfortably high twin deficits - are all well known, it is possibly time to ask when could the tide turn. And turn it will, analysts believe, once policy makers start showing a modicum of panic that the market is showing. After a 20 per cent fall in the currency, it is fair to assume that the overshooting will stop at some point, when the depreciation is overdone. Once that happens, the equity markets could start responding positively.

Analysis of historical data suggests that once the currency stops depreciating, the equity markets not only start stabilising but also start moving upwards. There are three episodes in India's currency history that resembles the current crisis when the rupee fell by over 20 per cent. The first instance was between July 1995 and February 1996, when the rupee fell by 20.6 per cent. During the 199 days of depreciation, markets fell by 4.5 per cent. The second was between March 2008 to March 2009, during which the currency fell 28.6 per cent and equities fell by 46.5 per cent during this period. The third episode of currency fall is more recent, when the rupee fell by 19.3 per cent between March 2011 and December 2011. The stock indices fell by 13.3 per cent during this period.

However, the interesting part is not the fall of the currency and equities, but how equities performed once currency stopped falling. One month after all three episodes of currency fall, the equities have given positive returns, averaging 10 per cent. Bank of America Merrill Lynch says in a note that since the focus is on the rupee, markets will stabilise only when it has confidence that the government / Reserve Bank of India action would lead to a stable currency going forward. The brokerage says in a note: "Historically, markets recover once depreciation stops. Looking at past instances of sharp rupee depreciation of over 15 per cent, the market has fallen in all the three instances on an average 21.5 per cent (ranging from 4.5 per cent to 47 per cent)." At the end of the depreciation on all three occasions, the markets have bounced back handsomely in the ensuing three months. So watch out for currency depreciation to stop.