Where is the Rupee headed?

Does anyone really care?

Currency markets, like their stock market cousin spring surprises when people least expect. Almost all exporters and dollar earners and spenders were caught off guard by the recent depreciation of the Rupee. While dollar earners lose the forward premium, the (oil) importers (dollar spenders) never bothered to cover their exposures. Who ever thought appreciation of the greenback?

The reasons for the sudden reversal were not far to seek.

(1) Recovery of the US dollar;
(2) Increased dollar buying by oil companies to meet rising oil import bill;
(3) Sinking capital inflows, choking the supply of dollars; and
(4) Unwinding of positions that were betting on rupee surge.

So where is Rupee headed? Surging oil import bill and expectations of moderating export growth suggest a worsening current account deficit this fiscal, likely to edge past 2% of GDP. It is said that a $10/bbl increase in crude price jacks up the trade deficit by around $6.5-7.0 billion. Higher global crude oil prices also boost remittances, but the net effect of higher oil prices on the current account deficit is still a large negative.

Back in 2002 when the first draft of Goldman Sachs BRIC report was in print, the rupee was at 49 to the dollar. The BRIC report forecast (and still does) that India would be the third-largest economy in the world by 2050 with an amazing 9% growth per year for fifty years. But something went unnoticed - it was in dollar terms. It also said in the first six years the rupee would be stronger by about 13%, which is exactly where it is today. Call it Goldman’s magic touch or just luck. For after all, the rupee didn’t get from 49 to 42 in a steady linearity. It rode up to almost Rs.38 to the $$ before getting to where it is today. So I think the flip flop will continue.

I pity all $$ borrowers that had raised ECBs and left the proceeds unhedged assuming a forever strong rupee. They should be losing some sleep now. The currency — like the broader economy — is mainly reacting to some near-term headwinds that have brought about a welcome correction in hype over the India story. India certainly has a story; at a very basic level. It could do with better education, healthcare and public infrastructure. The Rupee will find its own level depending upon how RBI is coping with its routine of non-intervention, trying to keep volatility low and creating awareness about risk and currency hedging.

Most importantly the Government has to learn to deal with political shocks – finding the Rs 60,000 crore largesse to farmers, then the Rs 25,000 cr largesse towards the government employees happiness fund. All of it will have an impact on fiscal deficit even if it keeps huge oil subsidy as an off-budget item.

So it is total chaos out there. Don’t fret over a number. Stick around and watch the fun and cash in on an opportunity as and when it shows up.
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FCCB has a short fuse

The Rupee appreciation and market declines have struck a double whammy to Indian corporates – especially those who have raised funds thro FCCB route during the boom times. I am not surprised. Most of them raised FCCB debt because it was available or worse, I-bankers goaded them into it. Now they grieve. Here is the Business Standard story.

It says “Non-conversion into equity may erode profits by 12% in FY09: Study”. I fear the erosion could be lot more if the study has provided only for annual interest outgo on FCCB borrowings. Let’s figure it out by a case study.

Take Amtek Auto (featured first in the list of companies in that report). It has $250 M (Rs.1000 cr.) in outstanding FCCB liability. I checked its operating profits [BSE CODE:520077] for CY 2007 (being the trailing four previous quarters) and its operating income is Rs.460 crores. (I hope the company follows prudent norms and accordingly assume the pro-rata interest on FCCB is included in the interest figure for respective quarters.) Now, after providing for depreciation and taxes, the company has a net income of Rs.257 crores.

As per the table, the market price of the stock is currently quoting at a 35.2% discount to the agreed conversion price of Rs.414. FCCB is due for maturity on June 2011. If the stock price goes further down or if it maintains below the conversion price, the liability shall remain as debt in its balance sheet and the company will have to provide for its repayment. Given the gloomy outlook, I don’t see the market getting back to its Jan 2008 peak levels any sooner and so would recommend providing for repayment of its principal (Rs.1000 cr) out of current profits. That would call for creation of a FCCB redemption reserve and transfer a sum of Rs.250 crore each year for 4 years between 2008-11. That would leave a net income of Rs.7 crores.

Now imagine the dent in the EPS. It’s earnings are currently at about Rs.16 per share. After creating the FCCB redemption reserve, it’s net income would stand reduced to Rs.7 crores and the resultant EPS would be Rs.0.63. Give it a liberal PE ratio of 16 as at present, even then the stock price would be a dismal Rs.9.90. That’s the emerging picture if FCCB leverage is taken out. The company may either choose to recap it with other means of finance of equal amount to sustain its liquidity and operating leverage. Even then, with the cost of debt going up, it may not be able to borrow at those low FCCB levels of 5.5%. This means higher interest outgo and lower EPS in the event the company is not able to accelerate its revenues or improve its margins. Both the options are unlikely since the company caters to auto sector that is rate sensitive and runs on low cost financing for sale of vehicles. That spells disaster for shareholders.

Now I have nothing against Amtek Auto as such. I just picked it up as it was figuring on top of the list in that table. But then this is a sufficient case study that highlights what over-indulgence during boom times can entail. Don’t bite off more than what you can chew.

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The Sound of Crash (is deafening)

RBI Guv Dr.Y.V.Reddy has heard us... Or is it the deafening thud of yesterday's market crash? Here he’s going soft on interest rates as opposed to his earlier tough stance against inflation. Ila Patnaik had argued that lower interest rates would help arrest inflation and the Rupee run since India would become a less attractive destination for foreign funds.

That report quotes RBI view calling for end-use restrictions for investments by foreign VCFs because of concerns on foreign capital inflows it is finding tough to manage. Ila Patnaik’s worst fears have come true - the central bank has been absorbing foreign currency inflows to check the rupee’s appreciation, but has ended up adding to the liquidity in the system.

I quote from that BS article. “Abundant rupee liquidity poses risks of higher inflation as it adds to the already high money supply. The year-on-year increase in money supply (M3) as on January 4, 2008, was 22.4 per cent against 20.8 per cent a year earlier and much higher than the central banks target of 18 per cent.”

With a crash like that, I’d rather the Guv comes up with some good news of lower interest rates, weaker Rupee or anything to perk up the market on 29th Jan, when he reviews the credit policy - and resuscitate the annual non-event that it has become lately.

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Strange things the Rupee does

The relentless run up of the Rupee has one major outcome. It drove xenophilic Indian companies like Infosys to focus on burgeoning Indian markets. Even as IBM, Accenture, Microsoft, Oracle, HP and other IT majors drove in to have a slice of the Indian market, Infosys was unmoved, stayed riveted westwards. It didn’t like the low margins. Sat smug under the illusion that juicy 25-30% margins that it kept gouging from overseas clients will remain forever.

I had written earlier about the short life of those obscene margins here and here and the folly of ignoring the domestic market. After getting dented in earnings and sensing a fast eroding market cap (and the worth of his own holding besides that of other co-founders), it looks like Kris Gopalakrishnan has heard me.

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It's another thing that he hardly had another choice...

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The trouble with more's

Rupee appreciation has cheered many a big corporates that had huge forex loans. But CFOs and auditors are jammed over its presentation to the taxman.

That is, the forex gain has two accounting options.

The gain can be (a) credited to the Profit & Loss Account or (b) represented in the Balance Sheet by crediting the gain to Fixed Asset account (reducing the cost of the asset).

Most big companies are unwilling to take the forex gains to P&L account. The forex gain, as income would increase their Minimum Alternate Tax (MAT) ) liability, which is often kept pushed to the floor. There is some confusion over prescriptions in Accounting Standards (AS-11 by ICAI) and what the law provides (Sch.VI of The Companies Act, 1956)

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A windfall doesn't always mean all round cheer, right...?

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FCCB rope trick

“FCCB offers thrive, especially when stock market and the economy are booming. Investments are made with an objective of generating certain amount of returns and reinvesting the money in other instruments. Once expected returns are earned, investors can exit without waiting for maturity of the bonds,” says Kiran Vaidya, head of investment banking, Religare Securities. Corporates are also benefited in that they can raise funds at a premium which is added to reserves and helps strengthen their net worth position, he said.

What Kiran - like most other I-Bankers - obviously misses out is its impact on the issuer (company) when Rupee is appreciating like it does now (1$= INR 40.50). The FCCB that stood as debt (borrowed when 1$ fetched INR 45) in the company’s books, becomes a high cost equity upon conversion (now when INR is dearer). Besides the impact of (unintended) cheap conversion, it dilutes earnings and has also to be serviced for life unless bought back. It's a triple whammy for the issuer !

Here’s what I think. Why not issue FCCB with the caveat - if the issuer’s domestic currency appreciates beyond a (hurdle rate) % during its pre-conversion term, the issuer shall have the option to repay the debt at an additional % point of interest over what has already been contracted…Law as it stands now, does not seem to have anything against this condition.

I think that would have saved the day for many issuers today. What do you think ?

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