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Santosh Mishra's Blog
When should you invest in Indian Assets
Oct 25 2012 | 3 Comments | 1745 Views

In a recent news item Assocham (an Industry body in India) reported that NRI remittances were expected to increase more than 19% in the current fiscal year (compared to last year) and expected to reach $75B. NRI’s repatriated funds from abroad to acquire domestic asset cheaply. In this regard, real estate has been a primary source of attraction for foreign investor and NRI’s as a combination of temporary low real estate price and cheap rupee makes it a good bargain. The focus of this blog, however, is broader and addresses an important question: If you are an NRI, then is this a good time to invest in Indian assets.

To answer this properly, it is first useful to understand the key underlying factors that drive return on investment. The focus for this piece is purely from the investment stand point and with a relatively short horizon.

There are two important drivers that determine return on investment in a foreign asset: (1) Interest rate (2) Exchange rate. We will postpone the discussion of type of asset (and the associated volatility) for a future post and solely focus on the risk free asset.

Interest rate is the king …
This is the simple one. Higher the interest rate, higher is the return. Everything remaining constant (alas they never do), the financial capital will chase the highest return. For example, India’s savings account deposit rate is close to 8%, compare that to paltry sub 1% in US banks and you will wonder why we all shouldn’t invest in Indian Rupee. Again, everything remaining constant borrow at 1% from US bank, put it in Indian bank at 8%, and after a year reap 7% return. Looks like free lunch right? Not too fast. We will ignore the sovereign default risk as India, thankfully, is not Europe yet and talk about the other dragon around the corner.

.. Only when exchange rate permits
We know everything never remains the same. Exchange rate can be the spoiler here. High interest rates mean nothing, if rupee loses value faster during the time of investment. We will explain this with a simple example. Assume that you converted $100 to rupee (Rs. 50 per dollar) and put it in bank with annual interest rate of 10% . After a year you collect the principal and interest together and it is Rs. 5500 (Rs. 5000 principal and Rs. 500 interest). However, lo and behold now the exchange rate is Rs.60 per dollar (economist call this depreciation of rupee). Converting back to dollar gives you Rs 5500/60~=$91. So you lost 10% on your investment. Similar maths will show that if the exchange rate had moved in rupee’s favor (appreciation) then your gain will be more than 10%. So the simple rule of thumb: Return= Interest rate + % appreciation of exchange rate (depreciation is nothing but negative appreciation).

Armed, with this simple yet useful rule of thumb, let’s look at the chart below to emphasize the point that high interest rate can be neutralized by plunging currency. The plot below shows the repo rate (the rate at which commercial banks borrow from RBI, which is also the benchmark risk free interest rate) and exchange rate. As to exchange rate( rupee per dollar), red line going up is bad for investment (as a given amount of dollar can buy more rupees) and red line going down good for investment. Looking at the data for the last 5-6 years provides a good lesson about investment strategy. For your convenience we have highlighted good time and bad time for investment in Indian asset.

  • Investor’s Dream: It is the combination of high interest, and appreciating rupee. This is what exactly happened during Jan’07-Dec’07. The combined effect of appreciating exchange rate and high interest rate yielded ~ 40% return during that period.
  • Investor’s Nightmare: As the chart shows, it happened twice: (1) From Jul’08-Jun’09, the interest rate plunged as RBIput our economy in the proverbial monetary respirator as the world economy collapsed. To add to the woe, rupee plunged during this period as investor fled from all emerging market assets. The consequence, a massive 23% loss during that period. (2) The other episode is more recent one, Jul’11-May’12. Here the interest rate kept rising, as RBI worked hard to kill the inflation demon but the massive depreciation of rupee took away all the benefit of higher interest rate. Net return: 11% loss on investment.

Services sector is doing well

… So Should I invest now or Wait
That is the natural next question. As this article shows it all depends on what we expect about interest rate and rupee’s strength. Here is our take: We expect interest to go down (despite the assertion to the contrary from RBI), the prognosis about rupee’s strength is more complex.

Our take is that the risk to world economy is lower today than six months back (better economic news from USA , calmer bond markets in Euro, and China’s supposedly hard landing was not hard at all). Improving world economy is always a good news for rupee, so on balance we expect rupee to appreciate for 2013 onwards (if not sooner). So even though the pure gain from interest rate is not high, strengthening rupee will make the investment return worthwhile.

 Our article concludes here for all practical purposes. Unless you like economics or voluntarily submit to torture you brain, you proceed further at your own risk.

The Joker in the Pack: Inflation What role does inflation play? We all know, high inflation is bad for the economy. Given a stable nominal exchange rate, high inflation means that exports become uncompetitive in the world market. Thus if India’s inflation rate is greater than the trading partner’s inflation rate then in effect the currency is appreciating in real terms (this one may be slightly complex to reason out, but trust us on this one). So the market expects the policy makers to intervene and devalue the currency (or engineer a managed depreciation) to avoid gaping hole in the current account. No sooner investors expect this, self- fulfilling prophesy will drag the currency down. In short, if you expect high inflation then stay away from those countries assets. It is a poisoned chalice.



Comments

  • By das rai, Jun 08 2013
    Plots are everywhere but the prices are also going up and always high, still peoples are investing so why not invest in some beautiful location near to neemrana-behror the delhi jaipur highway.
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