Depreciating Rupee Can TROUBLE MARKETS..

When most of the global markets are near or below their October lows, Nifty stands almost 20% above the same, despite any support from the macroeconomic side (Falling IIP, Rising Deficits, ... etc.). This I believe is mainly because over the last few months the Indian Rupee was one of the best performing currency among the other emerging market currencies (When compared to USD) and thus reducing the currency risk faced by the foreign investors.

The global fund managers while investing in any foreign country's equity (or bonds, etc) assign a high weight to the currency risk they face while investing. Investment in the country with stable currency commands lower risk premium against investment in country with volatile (weakening currency).

This is because a depreciating currency erodes the value of investment made. For example, If a FII invested $1000 in Indian markets when USDINR exchange rate was 40, he was able to invest Rs 40,000. After a year lets assume that their is no change in the value of investment (still Rs 40000) however the rupee has depreciated and the current USDINR exchange rate is 50 and he wants to take his dollars back. He would only get back $800 and thus given the value of the asset class he invested remaining the same he looses 20% because of a decline in the value of Indian currency.

What is happening over the last few months is that the Indian rupee is facing a stiff resistance at the 50 mark (and less volatile as its trading in the range of 48-50) because of the RBI intervention and since other emerging market currencies are depreciating, the flow of foreign funds is stable in India compared to other markets. Hence the Indian equity markets have outperformed others.

However today rupee has broken its strong resistance/physiological level of 50 and is currently trading around 50.30 and the downside risk & expected volatility is much higher now. (The technical analysts say that the next resistance is around 52-53 mark).

So I believe that because of this higher currency risk faced by the foreign investors (along with the fears of rising deficits, outlook downgrade by S&P, etc) a higher risk premium could be attached to India. Moreover as India is primarily an importing country this fall in the value of currency will also increase the trade deficits and hence the overall deficit.

Thus a falling rupee could lead to a fall in equity markets.