Corporate profits have dipped on every occasion when the rupee has depreciated against the dollar.

Experts are unwilling to forecast it. Companies are unable to hedge against it. And analysts aren’t factoring it into their calculations.

Yet, if the rupee heads down a slippery slope over the next ten years, it is likely to impact not just the economy, but your investment returns too. Here is why.

Lower profit growth for India Inc

For one, a steadily weakening rupee could significantly trim profits for India Inc. That would mean lower stock valuations and thus, stock price returns.

An analysis of quarterly profits of the 1,300 NSE-listed companies for the past five years shows almost a one-to-one correlation between trends in corporate profits and rupee’s direction.

Quarterly profits have seen a sequential dip in every quarter when the rupee depreciated. Consider 2008.

As the rupee weakened relentlessly through the year, India Inc reported one of the sharpest profit drops in recent times. If you dismiss this as a consequence of the domestic slowdown, there have been other instances too.

Between March and December 2011, as the rupee lost 16 per cent against the dollar, India Inc’s profits shrank by 14 per cent in absolute terms.

And the recent June 2012 quarter saw dramatic rupee depreciation (8.6 per cent), accompanied by a 8 per cent decline in profits. These numbers are without taking into account the numbers of oil refining companies. If they are included, the swings become much more dramatic.

Now, there are certainly many factors apart from the rupee (commodity price trends, interest rates, consumer demand) which impact corporate profits. But because it impacts profits in multiple ways — imported raw material, fuel, overheads, repayment of foreign borrowings — the exchange rate is a hard-to-ignore factor in India Inc’s profit picture.

Why the rupee makes such a difference to corporate profits is clear from an analysis of India Inc’s forex transactions over the last few years.

In the latest financial year, Indian companies, on an aggregate, spent 78 per cent more foreign exchange than they earned.

Net forex spending is on a rising trend too. In 2007, the import bill was just 50 per cent higher than export earnings in 2007. Nor is reliance on imports restricted to oil refiners. Excluding oil refiners, the value of imports for India Inc was still 30 per cent higher than exports.

Fuelling inflation

Two, every time the rupee slides against the dollar, it gives a leg up to domestic inflation. This is because a weak rupee adds directly to the prices we pay for crude oil, coal, basic metals, packaging and a host of other food articles such as vegetable oils and pulses, where we rely on imports to meet domestic demand.

Everyone knows that higher inflation trims the effective returns earned from investments.

Aggravating crisis

The third big reason why the rupee’s gyrations are a risk you should guard against, is that they tend to aggravate your losses during a market fall.

The story usually goes like this. A global crisis breaks out involving US housing/European bankruptcy/Dubai default (take your pick!). Foreign institutional investors (FIIs) take fright and want to park their money in safe havens back home.

They furiously sell stocks and bonds in emerging markets — India included — and rush the money back home. Result, the Sensex tanks sharply, bonds tank sharply and the rupee is plummeting too.

This sets off a downward spiral. Corporate profits shrink, FII returns deteriorate and valuations fall, all cutting into stock price returns. Rupee depreciation delivers a double whammy to equities by impacting both liquidity and fundamentals — the twin determinants of stock price returns.

But must one worry about the rupee weakening any further, given that it has already depreciated by 19 per cent against the dollar in two years? Well, this decline has been triggered by fundamental factors — a widening trade gap, a rising import bill on energy and gold and slowing exports. As there are no easy solutions to counter these trends, these fundamentals may remain shaky for the foreseeable future. So far, the country has relied on foreign investment flows to fund the widening trade gap. But experience tells us that these flows are far from predictable or stable. In fact, 2012 was the first year in recent history when the rupee depreciated (3 per cent) against the dollar, despite bountiful FII inflows ($24 billion).

This is why structural depreciation in the rupee is a risk that all investors must take seriously. It is better to be safe than sorry.

Aarati.k@thehindu.co.in

Read also: Guarding against a weak rupee

(This article was published on February 2, 2013)
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