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Avoid firms with high foreign debt

With companies announcing quarterly results and the rupee in doldrums, it’s a good time for investors to reassess their stocks. Falling rupee will affect company earnings and, eventually, stock prices for companies with high foreign debt.

business Updated: Jul 20, 2013 01:39 IST
Rajesh Kumar
Rajesh Kumar
Hindustan Times

The Indian rupee has fallen about 10% against the US dollar in the past two months and is now around the crucial level of Rs. 60.

This sharp depreciation in the rupee has numerous implications for the market. Since it affects dollar returns, falling currency affects investments by foreign investors, a dominant force in the Indian markets.

Further, it would lead to higher cost of imported goods, which will push inflation and will not allow the Reserve Bank of India (RBI) to cut interest rates and support growth.

In fact, the RBI has taken measures to curb liquidity in the market in order to defend the rupee and, in the process, has significantly reduced the possibility of an interest rate cut in the foreseeable future.

Count your costs

The more important factor, which deserves investor attention, is that falling rupee will affect company earnings and, eventually, stock prices for companies with high foreign debt.

A falling rupee will increase the burden for companies with foreign debt and can lead to value destruction. Let’s assume that a company is not hedging against currency.

Suppose company X borrowed $100 from the international market when rupee was at Rs. 50 against the dollar and converted its dollar loans and invested R5,000 (100x50=5,000) in creating capacity.

Since the rupee is now at Rs. 60 to the dollar and cash flows for the company is in the domestic currency, the company will now have to repay Rs. 6,000 (6,000/60=100) to its lender — a 20% increase in the debt burden. Similarly, the interest payment will also go up. The rupee cost of debt servicing will affect the profitability and stock prices.

With high interest rates at home and money was available in other parts of the world at much lower rates, Indian companies borrowed from abroad to take advantage of the arbitrage.

“For companies in the CNX Nifty (excluding banking and financial services), around 40% of debt is denominated in foreign currency. In total, corporate India had forex debt outstanding of over $200 billion as of March 2013, of which close to 45% is short-term debt,” according to a recent report from Crisil Research Only half of the exposure is hedged.

So clearly, a significant amount of earnings and balance sheet damage is waiting to unfold.

However, everybody doesn’t agree. “Unlike FCCB (foreign currency convertible bonds), majority of the outstanding ECB (external commercial borrowing) loans are with well established companies with relatively superior risk management practises in the Indian context. The immediate impact of rupee depreciation would be more of an accounting impact as such there is no need for panic as cash flow impact would be limited,” says Deep N Mukherjee, director, corporate ratings, India Ratings & Research.

The impact

It is evident that companies with high debt will get affected, though the impact will depend on the way the positions have been hedged.

“Companies with large foreign debt are at a significant disadvantage. The problem is that no one knows how much more the rupee will fall,” says Sudip Bandyopadhyay, managing director and chief executive officer, Destimoney Securities Pvt. Ltd.

However, Bandyopadhyay underlines that investors should not just sell in panic. They should evaluate the issue and then decide.

“Companies with high foreign debt will get affected but one will have to see which company will be hit to what extent,” says Daljeet Kohli, research head, IndiaNivesh Securities Pvt Ltd.

Kohli further argues that if a company has limited impact, investors should avoid exiting. The impact will depend on how the company is positioned on its foreign exchange exposure.

In any case, even in normal circumstances investors should avoid companies with very high levels of debt. And if the significant part of the debt is foreign, it should be a red flag.

With companies high on foreign debt, you are not only taking a normal business risk as an equity investor who understands the business of the company, but also a currency risk.

At this stage, with the given weakness in the macroeconomic environment, it is hard to predict how low the rupee can go.

There are numerous predictions floating in the marketplace, but it is clear that there will be downward pressure on the rupee in the foreseeable future.

Companies have started declaring their quarterly results and it is a good opportunity for investors with exposure in stocks with high foreign debt to reassess the issue and take a final call.

The rupee has seen significant depreciation in the June quarter and it will get reflected in the numbers. However, things could get a little more complicated.

Investors will have to look at the foreign debt damage in relation to valuation. If the stock has already witnessed price correction in anticipation, you may want to wait for the right price to exit.

First Published: Jul 19, 2013 22:39 IST