Rising rupee and IT stocks

What will be the stock market impact of the recent sharp appreciation of the rupee? Will the currency's strong gains provide additional momentum to any generalised de-rating of stocks caused by, say, a global move away from emerging markets?

This has been a key concern with the rupee rising notably from around 46/47 levels against the dollar last July/August to its current level around 41. This analysis focuses listed, export-oriented companies, in particular, the IT sector, what with its heavy export bias and the weights/influence IT companies have on the overall market indices and investment sentiment.

Benign impact so far

Going by historical evidence, further upward movements in the rupee's exchange rate will have no adverse impact on the overall stock market performance of the IT sector. To that extent, developments in the currency market may not provide a an impetus to any generalised withdrawal by global investors from "risky" emerging markets. (Actually, purely from a currency point of view, any sharp appreciation in the rupee would be even more welcome for that category of foreign investors for whom investment in the Indian securities market is more a play on the "undervalued" Indian currency rather than taking an exposure in "mainstream" companies. The focus here, though, is on what impact the rising rupee value has on the company earnings/margins and how that, in turn, will impact stock market performance.)

An analysis of the statistics relating to the IT sector's stock market performance (mirrored by the CNX-IT index, which accounts for as much as 90 per cent of the market capitalisation and traded values of the listed IT sector) in relation to the changes in the exchange rate of the rupee over the past five years points to this inference. If the foreign exchange exposure of the IT sector can be expressed in terms of the extent to which the stock market value (of the sector) changes in relation to a certain change in the level of the rupee's exchange rate, it can be inferred that the level of FX exposure of the sector is quite low.

In statistical terms, it has been noticed that the IT index's value changes only by around 0.30 times the change in the rupee's value.

And this measure of the relationship between the two data sets — the regression co-efficient — is also not statistically significant at the 1 per cent level of significance. In other words, one can be 99 per cent confident that the IT index's value does not change by more than 0.30 times the change in the value of the rupee. Not surprisingly, given the above data, the changes in the rupee explain only around 0.15 per cent of the change in the value of the index in the above period.

exports do well

What has perhaps provided the foundation for IT stocks' relative insensitivity to the secular upward trend noticed in the rupee's exchange rate in the past five years is the strong performance of IT exports in the same period.

The rupee has appreciated, on average, about 4 per cent a year in the past five years — from 49.05 in June 2002 to its current levels around 40.95/41. Software exports recorded strong growth in the above period — both in dollar and rupee terms. The growth in rupee terms is significant because it implies that the sector has been able to protect its final rupee realisations despite the secular rise in the currency.It is possible that the critical factors that enabled the sector to post good growth in rupee terms are:

Steady rise in export volumes in dollar terms and, more important,

A good level of hedging of the foreign currency receivables exposure.

Also, critically, the cost base of the IT companies/sector appears to have been systematically managed (lowered in relation to, say, income) as it is possible to protect/enhance margins despite higher FX hedging only with simultaneous action on the cost side.

Systematic hedging

Systematic hedging of the operating exposure (reflected in the increasing level of foreign currency receivables) has ensured that the rupee value of the underlying assets of the sector — broadly represented by the level of the index — is kept relatively immune to foreign exchange risk and is able to rise in tandem with the overall market.

As seen in the Table, software exports, which were around Rs 26,300 crore in 2000-01, have risen at a CAGR of around 30 per cent in the period up to 2005-06. In dollar terms, exports have risen almost at the same rate — rising at 31 per cent CAGR, from $5.75 billion in 2000-01 to $23 billion in 2005-06.

The growth in dollar terms has not been very much higher than that in rupee terms. But what is significant here is that the rupee growth rate has almost kept pace with the dollar growth rate. This points to a good level of hedging of the export receivables.

An example proves the point: In 2004-05, for instance, the dollar export figure was $17 billion. In rupee terms, this was around Rs 75,000 crore. This gives an average rupee rate of around Rs 44.10 per dollar. Applying this average rupee rate of 44.10 to the 2005-06 dollar export figure of $23 billion, one gets a rupee value of around Rs 1,01,000 crore. Against that, the actual rupee exports figure was as much as Rs 99,000 crore.

Given that the rupee has posted a secular appreciation in the five-year period mentioned above, the fact that in 2005-06 the export figure in rupee terms was only marginally short of what would have been the case if the same average rupee rate — of 44.10 — had prevailed that year, shows that software companies had broadly hedged their export receivables for 2005-06 at around the 44.10 levels. The same is the case with the other years too.

Overall prospects

Overall, IT stocks could continue to display robust valuations if stock market performance of the past five years and evidence from the sector's approach to managing business risk is any indication. The larger message for stocks/companies with an export bias is this: Begin implementing appropriate hedging strategies to minimise the level of risk.