Nifty CMP: 4517
The Indian stock market experienced significant selling pressure throughout June 2008, with Foreign Institutional Investors (FIIs) consistently being net sellers. This raises the question: why are FIIs exiting the market? Is it due to perceived vulnerabilities in the Indian economy? Let’s explore the relationship between the Yen, USD, and Rupee currency dynamics and how they impact FII behavior.
|
|||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
The Role of Yen Carry Trade
FIIs and hedge funds often rely on the Yen carry trade to fund their investments. The Bank of Japan (BoJ) lends money at an ultra-low interest rate of 0.5%. This allows investors to borrow in Yen, convert it to USD, and invest in higher-yielding markets, such as India.
Example of Yen Carry Trade:
Investing in emerging markets like India, with higher interest rates, can yield even larger returns.
Assume the Yen trades at 100/USD. A hedge fund borrows 100 billion Yen from the BoJ, equivalent to 1 billion USD.
If this amount is invested in a US bank offering a 3.25% interest rate, the profit is the interest rate differential:
3.253.25% – 0.5% = 2.75%3.25
This translates to a profit of $27.5 million without taking significant risks.
Impact of Currency Volatility on FII Behavior
While the Yen carry trade is lucrative, it’s not without risks. Currency volatility plays a significant role in determining its viability:
- Yen Appreciation: If the Yen strengthens (e.g., from 100/USD to 96/USD), hedge funds need more USD to repay their Yen loans, reducing their profits.
- Yen Depreciation: If the Yen weakens (e.g., from 100/USD to 108/USD), repayment becomes cheaper, encouraging funds to stay invested.
In June 2008, the Yen depreciated from 104/USD to 108/USD, a 4% decline. However, the Indian Rupee depreciated more sharply, falling from ₹39/USD to ₹43/USD—a 10% decline. This mismatch made investments in India less attractive for FIIs.
Currency Mismatch and FII Selling
The steep depreciation of the Rupee, coupled with high inflation in India, led to a negative sentiment among FIIs:
- Increased Costs: A 10% depreciation in the Rupee meant FIIs effectively lost value on their investments when converted back to USD.
- Inflation Pressures: Rising inflation reduced real returns on investments.
- Mismatched Rates: The Rupee’s sharper depreciation compared to the Yen (10% vs. 2%) increased the net interest burden on funds.
Implications for the Market
As of June 2008, the following trends were observed:
- The Yen’s depreciation to 108/USD slightly eased FII repayment burdens, but the Rupee’s sharp fall offset these benefits.
- The mismatch between the Yen, USD, and Rupee created unfavorable conditions for carry trade-dependent FIIs, triggering large-scale selling.
If the Rupee continues to weaken beyond ₹44/USD, the Indian market could face additional selling pressure. The Reserve Bank of India (RBI) must intervene to stabilize the currency and address inflationary pressures, which are expected to touch double digits soon.
The interplay between currency fluctuations, inflation, and interest rates has created a challenging environment for FIIs. The mismatch in the Yen, USD, and Rupee dynamics underscores the vulnerabilities of relying heavily on foreign investments. Policymakers and investors must remain vigilant as these factors continue to shape market trends.
