Is currency fluctuation an opportunity? MARKET INSIGHT

If companies with foreign exposure are beaten down, investors could engage in bargain hunting

The Brexit fallout has already led to one burst of volatility in currency markets. There will be more as the situation evolves. India is significantly, but not frighteningly, exposed to such volatility. The latest Reserve Bank of India data tell us that external debt was around $486 billion in March 2016. That is a moderate 24 per cent of the gross domestic product (GDP).

Commercial borrowings constituted around 37 per cent of external debt, with non-resident Indian (NRI) deposits (26 per cent) also being a large chunk. Trade credit had dropped 15 per cent in March 2016 over March 2015. Overall, foreign commercial borrowings rose only 0.4 per cent year-on-year to $182 bn (Mar 2016) from $180.6 bn (Mar 2015). About $29 bn of commercial debt (or about 16 per cent) has a residual maturity of one year or less.

Dollar-denominated debt was the largest component (57.1 per cent at end-March 2016), followed by rupee-denominated debt (28.9 per cent), International Monetary Fund’s Special Drawing Rights (5.8 per cent), yen (4.4 per cent) and euro (2.5 per cent). So, there is no significant direct exposure to pound. However, a hardening of the dollar and the yen could put pressure on borrowers with exposure to those components. About $207 bn is due for redemption within a year. This would be the component that faces the most stress. This shortterm debt includes about $90 billion of NRI debt, which must be redeemed or rolled over within a year. That includes $34 bn of swaps, which are due by December 2016.

The rest — about $117 bn — has several components. As mentioned above, $29 billion consists of external commercial debt. The bulk — about $83 bn — consists of investments by foreign portfolio investors (FPIs) in rupee treasuries and rupeebased Commercial Paper. In these cases, the exchange risk is generally borne by the investor, rather than the borrower.

The dip in trade credit and the low commercial debt expansion indicates how much of a slowdown there has been. Exports dropped year-on-year for 18 months in succession before finally easing upwards in June 2016. Companies with short-term external exposures must brace themselves for possibly violent fluctuations, which could result from Brexit. But it’s not always easy to figure out how a specific company will be affected. Companies with foreign exposure tend to have both forex costs and forex earnings. Broadly, a weaker rupee helps net exporters and a stronger rupee helps net importers. A borrower with foreign exposure will, however, want a stronger rupee unless it has export earnings. An exporter that is carrying foreign debt might not have a straightforward relationship with the rupee.

A sub-set of the ‘importer’ for example, is the corporate that pays royalties or licence fees to a foreign parent. Think of Maruti, for instance. It prefers a weak yen since it imports parts and pays yen-denominated royalties. But, Maruti also exports cars and those might be driven by a weaker rupee. There are also companies with large subsidiaries abroad like Tata Motors, Tata Steel, Hindalco, etc. In a case like Tata-JLR, the subsidiary has a larger balance sheet than the parent. Corus Steel was a very big bet on a European steel business for Tata Steel. Hindalco owns a major Canadian aluminium player, Novelis. Bharti Airtel is another company with a large presence outside India and the telecom major could see higher growth abroad. Apart from this, debt raised abroad in hard currencies could be of many types. There is vanilla debt. There are nonconvertible bonds; there are convertible bonds. In addition, the borrower might, or might not, have foreign earnings.

Therefore, foreign debt has to be examined on a case-bycase basis. It is reasonable to assume that a borrower faces greater risks, unless it has strong foreign earnings. If there’s a conversion-to-equity option, investors must also look at the trigger levels and trigger conditions. Foreign direct investment (FDI) is another class of instruments. FDI flows are affected by foreign exchange (forex) volatility, as there is a tendency to postpone committal FDI decisions when there are major currency fluctuations. FPI flows usually enter and exit with more short-term aims and FPI flows will ride currency volatility, one way or another.

As and when the next bout of currency fluctuation occurs, the market will probably react in kneejerk fashion by hammering all companies with foreign exposures. If the wrong stocks are beaten down to bargain basement lows, there might be investment opportunities.