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Understanding Rupee Fall in Context of Fundamentals

Brief write up explaining the rupee fall / stock market fall etc., integrating with basics of Financial Management / Valuation in play...

Currency (in our case Rupee) depreciating / appreciating shall depend on Countries ability to repay its debt obligation. This obligation gains strength from the country to generate revenues in excess of its expenses. India has constantly adopted a policy of funding its gap in this via issue of Currency. So, as this deficit increases there will be higher supply of money in the economy.

Now, in out current situation, the country is sitting on huge Fiscal and Current Account Deficit; this deficit is nothing else but higher expense vs. country's ability to generate higher revenues.

Currency is a function of interest or in a rather financial term yield. Yield is nothing else but interest you will receive against your debt / bond purchased. Consider a country as a company. If a company is loss making then its bond will keep falling. So if India issues a bond of say Rs. 100 at 8% its yield under normal circumstance should be 8%. If our country keep performing; then the value of this in open market will increase to say Rs. 105 with rate of interest at 8%; this yield will be 7.6%. Now, country goes into economic upheaval; then this bond value go down to Rs. 90; taking bond yield to 8.9%. If bond yield increases, would mean risk increases. If risk increases the sole measure for country is its currency; so currency will decline.

Now, coming to stock market falls. With increase in bond yield, the valuation of stocks or market will decline. Stock are generally value based on future expectation. Everything else remain constant, the cost of equity is generally denominated under a CAPM model which is Risk Free Rate + Beta of stock x Market risk premium. If expect growth in all 30 stocks in Sensex remain same but for valuation Risk Free rate increse from 8% to 9%; then automatically the discounting factor increase (discounting future revenues) and market risk premium increases. Because, with higher yields; investor will demand higher return from stocks. So, based on increase in cost of capital due to change in yield, the perception for stocks with investor expecting valuation at lower level.

one more corollary comes from depreciating currency is higher yield. So, in our case all capital project stalled will have to completed at a higher cost of capital. So, suppose a road which was costing Rs. 1000 cr., could be done with debt at 8% will have to be done now at debt at 10%; which reduces expected revenues.

This is explanation is the basic economic / financial principle. Upon this basics, all things work; so with this perception coming fast, we see exits / sell off in stock markets by FIIs. Further FIIs, measure risk in invested in Dollar Denominated Return; so if FII invested Rs. 1000 and earned 10%. This was possible when Rupee was 50; however, now Rupee is 60; which is an appreciation of ~18%; so his gain of 10% is wiped off. To ensure his portfolio is not further decimated, he will exit and try to salvage losses. Upon this u can add all jazz of non performance of government etc.

Follow-up post soon....