Indian Rupee is now witnessing lower depreciation vis-à-vis the US Dollar and its volatility is at decadal lows
An important component of the cost of capital for any domestic project, which relies on external financing whether debt or equity, is the change in exchange rate. To a foreign investor investing in a domestic project, the return that matters is what they can repatriate back in their own currency. The exchange rate, expected in the future when repatriation is planned, plays a very crucial role in determining the expected rate of return. A foreign investor will want to cover the expected depreciation in the value of the local currency when formulating their cost of capital.
Understanding the average depreciation…
Knowing what the future exchange rate will be is difficult, especially when the hedge market is broken. For emerging market economies, exchange rate hedges are liquid and competitive largely in short tenures like say a year or so. For investors with a long-term horizon, the ability to hedge currency rate risk over a long period of time may simply not exist. Long term investors may invariably end up taking unhedged currency risk on an emerging market investment. It is possible to roll over short term hedges over multiple periods but typically that is uneconomic.
Since the future is unknown, one typically looks at the past for guidance. Investors assess what has been the realised depreciation of a currency over rolling, long periods of time. Understanding these changes in exchange rate over multiple cycles offers a reasonable estimate of the annual rate of change between them (appreciation or depreciation).
The realised annual rate of change between currencies offers a good starting point for investors to consider what premium to associate with the currency when calculating the cost of capital. For example, if a currency has reasonably consistently seen say, a 4% depreciation every year, and if past is assumed to be a reasonable representation of the future, an investor would add 4% premium to the cost of capital in that currency.
…and the volatility of the change
While the realised depreciation represents the outcome that we see on a particular date, it should rightly be seen as one of the many outcomes that were possible. Since the future is suffused with uncertainty, investors typically do not like to take a single point estimate of the future. A range of outcomes is considered: the best way to estimate what the range of outcomes can be is to understand the volatility in the movement of the currency. The more volatile currency, the more it is possible that the realised outcome in future can be significantly different from the average assumed. As an investor, the expected return needs to consider close-to-worst possible outcome.
Currency volatility is measured by the standard deviation [also called sigma] of the changes in the exchange rates. Knowing the sigma, a range of outcomes can be forecasted. Without being too technical, suffice it to say that a three-sigma range is expected to cover 99.7% of the possible future outcomes (assuming a normal distribution). A currency with an average 4% depreciation per year coupled with 10% volatility has a three-sigma range of outcomes represented by 2.8% to 5.2% of annual depreciation every year. [The maths is: 4% +/- 3 * (10% of 4%)]
The foreign investor would hence add premium of 5.2% to the cost of capital for that currency, instead of the 4.0% average expected depreciation, an increase in cost of capital of 120 bps.
Putting both together in the cost of capital
The investor is now more confident of having protected the close-to-worst outcome possible, even though it raises the cost of capital for the recipient. Foreign exchange risk (premium) component is, hence, composed of two parts: (1) the expected depreciation, and (2) the volatility of the expected depreciation. If a currency is more volatile, its cost of capital rises, and vice versa.
Structural factors can change the relative trajectory of exchange rates, impacting both average depreciation and volatility. In a recent OpEd in this paper (“Decoupled from the US”, Apr 17, 2023), we had noted that the relative inflation differential between India and the US has narrowed leading to lower yield differentials between the two countries. This is largely attributed to a significantly better inflation management in India compared to the US, especially post India’s implementation of the flexible inflation targeting regime of 4% +/- 2%. We note that the yield difference between the 10-year sovereign bonds of India and the USA is now at all-time lows of ~3.2%.
INR seeing lower depreciation and volatility
India’s relatively better performance on inflation management has meant that its rate of depreciation against USD has been low and falling. More pertinent, the realized volatility of INR vis-à-vis USD is now at decadal lows.
INR structurally moved from a 4.0% depreciation with a sigma of 7.6% (as observed in the three-year period between Jul 2013 and Jun 2016) to a 2.8% depreciation with a sigma of 5.0% (as observed between Jul 2016 and now). This change means that the third standard deviation from the mean moved from 4.9% to 3.2% over these time periods, a reduction of ~170 bps on an annualized basis.
Lower depreciation coupled with lower volatility, if sustained, can bring down the required risk premium that foreign investors charge on Indian investments. Savings on the lower cost of capital can be material. Such reduced cost of capital can be attributed to the deft management of the external value of the rupee. The central bank, through the course of the last couple of years, has managed its large stockpile of foreign reserves countercyclically to dampen the volatility. The RBI has consistently maintained its mantra on foreign exchange: to “not target a level but manage volatility”.
The author is with the National Investment and Infrastructure Fund Limited. With inputs from Akshata Kalloor and Abhijeet Awasthi. Views are personal.
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