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Dealing with a weak dollar

November 02, 2009 12:08 IST

In the 1980s, when inflation was running at over 10 per cent a week in Brazil and Argentina, the Latin American giants took desperate measures. Both countries sliced several zeros off their currency.

Then, Argentina "dollarised" the economy. The Argentine central bank stopped issuing local currency, except at a fixed rate against new accretions to forex reserves.

This led to immediate hardship as street prices rounded upwards to reflect the fact that the USD was worth thousands of pesos. But it eventually worked, bringing down inflation by constricting money supply and preventing a run.

The Brazilians tried orderly devaluation. They depreciated their currency by a fixed amount every month. This also prevented a run - while the currency was unstable, it had a clear trend and a predictable rate of decline.

Almost three decades down the line, the dollar itself is under attack. The US economy is weak and it's running massive deficits. The huge gap between government expenditure and revenues causes one sort of tension, impacting US interest rates. The massive trade gap leads to another sort of pressure on the value.

As a result, the dollar has seen sharp depreciation and it hasn't been orderly either. However, there hasn't been an inflection point, where the currency goes into freefall. Nor is that sort of collapse likely, unless the Chinese decide to rebalance exposures in US treasury bills. There may well be a point when the downtrend reverses, even if temporarily, because traders think the currency is oversold and due to bounce.

Let's look at the impact on India. Since Indian exports are largely dollar-denominated, a strong dollar hurts exporters. This means pharma and IT companies would be reasonably happy with the current scenario since a weak dollar leads, other things being equal, to better price competitiveness and eventually better volumes.

At this instant, it could be a moot point since the US economy is still very weak. There has been some evidence of growth in dollar terms, quarter on quarter, in the latest returns so perhaps this effect is filtering through.

There are several other areas of impact. Both FDI and FII flows could increase for two related reasons (apart from attractive Indian markets). One is because investors may speed up commitments for fear that it will fetch less value later due to depreciation. The other is cash fleeing a weak economy and heading for a strong one.

Another possibility is rising commodity prices in international markets. Despite anaemic global GDP, commonly traded metals, and crude, etc., have all seen nominal price rises and could move further North. This is because although the prices are USD-based, the producing economies are not.

Hence, there's been a rise due to the weakening greenback. For the same reasons, bullion markets have seen strong trends in gold (and to some extent, silver). Gold is a hard currency and it has risen versus the greenback just as the Euro, sterling and Yen have.

In terms of equity investments, the focus would be more on pharma rather than IT. Demand for IT services have improved but they are still weak. Pharma on the other hand, has more stable revenues in general. Both industries have reasonable valuations compared to growth projections and to the rest of the field.

Betting directly on the dollar is possible through the dollar futures on NSE. That instrument is generating massive volumes.

However, selling the dollar via this instrument carries the same risks as any other short-term derivative. If there's a short-term bounce back in the November settlement, anybody selling the dollar will lose. Longer-term contracts probably carry less risk.

Another possibility is commodities. Betting long on metal prices directly is possible at MCX. It is also possible to buy into metal-producing companies. Indeed, this appears to be the case with non-ferrous stocks like Hindalco, Sterlite and Hind Zinc.

One would also recommend a look at gas and crude producers but there is policy risk there, especially until the RIL-RNRL issue is sorted out.

All these possibilities depend on a few assumptions. The most important one is that the US economy will continue a slow recovery. Either a sharp bounce or another collapse in US GDP will overturn the current trend.

Devangshu Datta in New Delhi
Source:
Tags: USD, US, NSE, FDI, MCX