IT and pharma start to catch up

A falling rupee will improve valuations of these sectors

The rupee has fallen 5 per cent against the dollar since January 1, 2018. It's fallen more against other currencies, by 6.5 per cent versus Euro, 8.2 per cent against the Yen and 8.5 per cent against the pound. The dollar has lost ground versus most currencies. 

Given that the trade deficit and the current account deficit (CAD) are rising, the rupee's weakness is beneficial. The trade deficit hit $157 bn in 2017-18, while the CAD rose to 1.9 per cent of the gross domestic product (GDP).  This is despite good export growth of nearly 10 per cent.  

There was a 26 per cent surge in the value of crude imports, and 25 per cent rise in electronics imports and a sharp 45 per cent rise in the value of gem imports. Expectations for 2018-19 include a widening CAD of 2.75 per cent of GDP. That's in worrying territory. 

A weaker rupee makes exports more competitive and imports more expensive, reducing demand for imports.  Given the rising CAD, the rupee could slide lower if the Reserve Bank of India (RBI) allows it. There are substantial reserves - enough for ten months import cover. Also, if the foreign portfolio investors (FPIs) continue to buy rupee debt and rupee equity, that would prop up the currency to some extent. 

While a weaker rupee will help exporters, there are other possible impediments to higher exports. One would be even greater weakness in the currencies of competing exporters like Bangladesh and Vietnam. Another issue could be barriers of the sort that President Donald Trump is threatening. For example, Indian exporters will be hurt if America rescinds India's privileges under the ‘Generalised System of Preferences’ (GSP), since many Indian exports receive tariff relief under the GSP. 

Two sectors have consistently headed Indian exports. One is pharmaceuticals and the other, information technology (IT). However, IT and pharma have suffered through the last few years due to factors other than currency strength. 

The US market for generic drug imports is critically important and pharma companies have trouble meeting the stiff standards of the US FDA (Food and Drugs Administration). Inspections of manufacturing facilities have often led to embarrassment. 

In addition, the Trump Administration has made noises about cutting off access for drugs imports. It proposes to raise tariffs on Chinese drug exports to the US and there are fears it may do the same for Indian drugs. 

Revenue growth for the Indian IT industry has been quite slow in the last three years. That's partly because the global economy was growing slowly and partly because Indian companies have missed the bus when it comes to new technologies such as digital, the Cloud and AI. 

Most IT companies have had to hike wage bills due to a tougher visa regime that forces them to hire more US-based professionals. The Brexit remains a threat that could compel UK-based companies (not just IT companies) to open new headquarters in the Eurozone to maintain access to the EU. 

The growth guidances declared by IT companies for 2018-19 so far have not been optimistic. Infosys and Wipro have disappointed, TCS has just met expectations. However, these are constant currency estimates, which means that a weaker rupee could have a significant positive impact. Given that global growth is accelerating, the revenue guidances are perhaps, conservative anyhow. 

The market has, however, discounted all these issues. Both the pharma and the IT sector have seen valuations falling steadily in the last three years.

In calendar 2015, the Nifty had an average price-to-earnings (P/E) ratio of 22. It had an averaged PE of 24.7 in calendar 2017. In the last 12 months, the Nifty has returned 14 per cent in capital appreciation. The NSE Pharma Index had an average PE of 57 in calendar 2015 and an average PE of 40 in calendar 2017. In the last 12 months, the Pharma Index has lost 13 per cent. The NSE IT Index had an average PE of 21 in 2015 and an average PE of 17 in calendar 2017. In the last 12 months, the NSE IT Index has gained 39 per cent. 

IT and pharma would have to overcome the issues mentioned above to reap the full benefit of a weak rupee.  But it's likely that valuations will now start to catch up with the broader market, as the rupee falls.