Corporate earnings in the second quarter have been driven more by the effect of rupee fluctuations than changes in the domestic economy. Exporters have done well and so have businesses benefiting from import substitution. Importers have suffered. Sectors, such as power, construction and cement, which are dependent on domestic investment, haven't done that well.
In the five-month period, April-August, dollar-denominated exports rose 3.9 per cent to $124.4 billion, while imports grew 1.72 per cent to $197.8 billion, leading to a trade deficit of $73.4 billion. This is about 9.64 per cent of FY14 GDP of $1.826 trillion, according to the PM's Economic Advisory Council estimates. It is lower than the deficit of $74.7 billion, which amounted to 9.7 per cent of the FY 2012-13 April-August GDP of $1.841 trillion.
During this time, the rupee dropped considerably. It moved from Rs 54.35/dollar in early April to below Rs 66.5 in late August. This was in some senses, a natural corrective to the massive trade deficit of $191 billion in 2012-13.
The downside to a weak rupee is simple. It adds to the inflationary pressures on the economy. In particular, crude oil, gas and coal imports have become more expensive. Even this might actually have been a good thing since it forced some reforms in the sector.
The lower rupee had several beneficial effects to balance the inflationary effects. One was that it reduced imports since those became expensive and thus, it provided protection to Indian manufacturers selling in the domestic market. Also it boosted exports. The third thing was the currency fall made Indian corporates averse to forex-denominated external commercial borrowings reducing the danger of external debt-obligations going out of control.
All these effects will continue to be evident but in reduced measure. The rupee has pulled back to Rs 61-63 and apparently stabilised at those levels. Compared to April, that's a currency depreciation of 14-15 per cent, as opposed to the slide of over 20 per cent during the second quarter. Will this measure of depreciation be enough to maintain the same trends for the second half of 2013-14? It may be because the economy and all its players had time to adjust. Policy makers aren't panicking anymore and exporters and importers have faced up to the reality of a weaker rupee.
If the currency rates stay more or less stable, or there is a steady predictable trend, a weaker rupee will be the least painful way to rebalance the Current Account. However, volatility on the currency front could be difficult to handle. It is extremely unlikely that the rupee will rise much. While it seems the Reserve Bank of India is prepared to hike rates to curb inflation, US interest rates are also likely to harden as and when the tapering of QE3 occurs. Indian GDP growth isn't expected to accelerate meaningfully in the second half.
Apart from the obvious export-oriented sectors such as information technology and pharma, I'd start looking at a few others. The Indian automobiles and auto-ancillary sectors are likely to show healthy export growth, even though the domestic scenario might remain depressed. These sectors have probably hit their cyclical bottoms. Textiles and jewellery exporters could also get some boost - this hasn't really been evident in Q2 but the come through on an extended run of rupee weakness. These equity plays would be medium-term with a perspective of a 12-18 months.
The other interesting trading possibility lies with the rupee itself. If the US taper starts in January, look for another spell of rupee weakness at that period. The dollar is very likely to harden at that point - there will be FII money pulling out of India and other emerging markets. It is possible that the rupee could fall suddenly and steeply, since there will also be increasing political uncertainty as elections draw nearer. Although forex leverage ratios are always very high, making these trades risky, a long dollar position could be worth gambling on when the Fed does taper.