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There is confusion about the currency trend with the rupee's gyrations hitting headlines on a daily basis. The recent Deutsche Bank advisory that the rupee could hit 70/ USD within a month has been getting a lot of attention. Couple it to a Crisil advisory that suggests the rupee will be back at 61 in six months to a year. Add in the Finance Minister's contention that the rupee is undervalued.
All of them could be right. There is a run on the rupee and it may get pushed to the 70 mark or beyond. There may also be a point where the market realises that the currency is deeply under-valued and a recovery will start. Thus, it may bounce back till 61.
Currency valuation depends on multiple factors and can never be calculated exactly. There are relative levels of growth and inflation in different countries. There is a quantum of imports relative to exports. There are investment flows in and out.
The RBI uses a formula, called the Real Effective Exchange Rate. The REER calculations compare the rupee's purchasing power and Indian wholesale price index inflation (WPI) to the purchasing power and consumer price inflation (CPI) of baskets of multiple currencies. This is not an apples to apples comparison. WPI and CPI are different and the rupee is partly convertible, whereas quite a few of the other currencies are fully convertible. But for what it's worth, the REER levels suggest that the central bank thinks the rupee should be around 61-62.
Other investors and banks use different models to calculate likely exchange rates. There will be phases when market exchange rates are not in line with the models and investors will see those mispricings as opportunities.
There are two big reasons why I advice small traders speculating on currency movements to be very careful. One is that currency futures and options are very highly leveraged. The other is that the RBI wields extraordinary powers because the rupee is partially convertible. The central bank could do many things to influence currency direction and in extremis, it could impose capital controls.
The textbook solution to a big current account deficit (CAD) is to aim for a big currency devaluation and to keep the currency under-valued for a substantial time. A weak rupee would boost exports. It would also retard import demand and make external borrowings unattractive. Taken in conjunction, this should mean a CAD reduction.
Unfortunately, this is politically unacceptable. It would mean higher domestic inflation in an election year. Rupee energy prices would rise. It would also swell the fuel and fertiliser subsidies, or force the government into hard policy decisions about cutting subsidies.
Another possibility is to convince the IMF to come up with a package that tides over possible external balance of payment problems. Any such package would come with conditions attached. Those conditions would undoubtedly include cutting fuel and fertiliser subsidies and probably, delaying or shelving the Food Security Bill. Again, politically unacceptable.
If India does allow deep currency depreciation, growth could jump. It would be a roller-coaster but there would probably be a short, deep bear-market, followed by a quick recovery. If it goes to the IMF, or finds other ways to finance the CAD, the outcomes will be similar.
If India doesn't formulate policies to reduce the CAD, the market will force a CAD reduction anyhow. Overseas lenders will become increasingly cautious about India. Portfolio investment will drop. GDP growth will slow further. Under such circumstances, inflation may not rise much, but it will not fall either. This stagflationary scenario may already be a reality and if it is, we will see a bear-market with prices drifting down slowly over a long period of time.
During stagflation, growth is reduced, cutting down chances of finding multi-baggers. Another issue is that debt is also reduced in value. In the early stages of stagflation, it is better to invest in short-term debt and essentially hoard cash. Interest rates tend to rise rapidly once stagflation takes hold and the recent rising trend in government bond yields suggest that this will happen.
Equity investments tend to do better if they are geared towards interest rate-neutral sectors rather than rate-sensitive ones. Apart from the obvious plays of exportoriented industries, FMCGs are good defensives. Precious metals are difficult to judge since gold and silver rates are driven by global factors and there is some evidence that the US can pull global GDP growth back up. Realty and financials will only be good options if there are deep corrections.
