Is Exchange Rate The Dominant Factor Influencing Corporate Profitability in India?

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1 Is Exchange Rate The Dominant Factor Influencing Corporate Profitability in India? In pre-reform era, the Indian corporate sector played a passive role in economic development mainly due to strict regulations on maintaining debt equity ratio in different industries, managing working capital or availability of credit at administered rates with almost no relation to the creditworthiness of the domestic currency would result in a decrease (increase) of net external non-trading dues of a company in terms of domestic currency in the form of net interest payment on external debt, net dividend in forex, net capital repayment in forex, and fees, commission, royalties to be paid in forex, corporates. Post-reform, the corporate sector etc. registered considerable growth and due to its Similar to exchange rates, interest rates may also increasing strategic importance for achieving higher have a direct effect on corporate performance. A rise GDP growth, policy makers started examining the in interest rate would jack-up the interest outgo link between the corporate sector, financial sector thereby increasing expenditure and reduction in and the economy and also monitoring their health profitability. However, this might be different in the and performance. Gradual opening of Indian period of stress in the forex markets. economy, greater integration with world economy and increasing reliance on market forces may have The importance of firm-specific characteristics such reinforced the importance of macroeconomic as firm size, leverage, liquidity etc., in explaining the factors like exchange rates and interest rates to performance of private corporates has been determine corporate performance. Furthermore, in documented in many recent studies. The importance the aftermath of the global financial crisis , of macroeconomic factors like exchange rate, the correlation between the exchange rate and corporate performance was expected to be amplified further. interest rates and the WPI inflation rate to determine corporate profitability was accepted by several scholars. Traditionally, various indicators have been used to measure corporate performance. Return on The depreciation of the domestic currency makes the assets (ROA), return on equity (ROE), return on export cheaper and the import costlier which may investment (ROI), return on sales (ROS) and profit have a positive impact on the performance of firms margins are most commonly used measures. exporting their products simultaneously making a negative impact on the performance of the firms importing raw materials. The appreciation (or depreciation) might have an indirect impact also. An appreciation gives foreign firms a cost advantage, intensifies the competition for domestic firms in both domestic and export markets and hence In this paper authors used ROA and EBT margin which is the ratio of earnings of a firm before taxes to sales. To examine the various factors influencing corporate performance, ROA for annual data and EBT margin for quarterly data are regressed on a set of control variables which were divided into firm adversely impacts the firm's profitability. specific factors and macroeconomic indicators. In Furthermore, an appreciation (or depreciation) of order to identify factors influencing corporate Working paper by Shaoni Nandi, Debasish Majumder and Anujit Mitra, Department of Economic and policy research, RBI, August

2 SUMMARY profitability, the authors divided total sample period in to two sub groups i.e. pre-crisis period (Q1:2002 to Q4:2007) and post crisis period (Q1:2009 to Q3:2014). The authors performed panel regression based on annual and quarterly data separately for the total sample and also for above two sub periods. Based their studies, the authors found that during corporate profitability was mostly influenced by firm-specific indicators like firm size, leverage, liquidity etc. However, since 2009, the domestic economy became more integrated with the global economy and also more sensitive to external shocks. Simultaneously, the importance of macroeconomic factors like exchange rate, interest rate and the WPI inflation rate to determine corporate profitability is amplified. Among the macroeconomic indicators, the USD/INR rate was a significant factor whose importance has increased manifold in the recent time. Panel regression showed that exchange rate is negatively associated with corporate profitability indicators (viz. ROA for annual data and EBT margin for quarterly data). This means that when rupee appreciates, corporate performance is likely to get a boost in terms of profitability. They also observed that when forex market is in stress, the exchange rate becomes the only critical factor to determine corporate profitability, dominating all other factors. Source: 12

3 Public Debt Management in India and Related Issues This study focuses on the marketable domestic public debt of the Government of India (GoI) in terms of size, magnitude, policy and approach followed and also discusses issues and challenges on debt management. In a deficit liquidity scenario, the main determinants deciding the yield in the primary auction may be the ruling short term interest rate (repo, MSF). The paper focuses on how far these short term factors influence the yield in the primary auctions. In its endeavour as a debt manager, the RBI has adopted objectives of minimizing the cost of borrowings for the Government, maintain acceptable rollover risk, develop deep and liquid bond market and widen the investors' base. However, there are various issues and challenges that confront the debt management in the Indian context. First, the gross market borrowings of the GoI and States together have more than doubled in the current decade leading to enhanced supply of government securities, which demand higher yield leading to higher benchmark rates which feed in to inflation through input costs and push up the benchmark thereby creating a vicious cycle. It may also increase the spread between the GoI and comparable securities and would pose a risk for smooth and orderly conduct of debt management operations and also a challenge to the basic objective of borrowings at a lower cost in the medium to long run. Secondly, the sustainability of debt requires governments to be both solvent and liquid; however, India stands well off on both these grounds, with the debt-gdp ratio steadily declining. The third challenge is to improve the resilience of debt structure and strategy. In India, as part of prudent debt management strategy, the RBI has elongated the maturity profile of the outstanding stock of G- Secs by issuing securities of longer maturity in order to minimize the rollover risk and by capping the debt repayment in a particular year. The fourth challenge is to curtail demand side risk and promoting retail segment for government securities. Demand side risk could be addressed through spreading the issuance of securities along the yield curve during the year, which would increase the attractiveness to investors and reduce the liquidity premium that investors demand. This would also reduce the risk that the pricing of government securities are usually affected by the actions of a small number of captive market participants. In India, though the reserve requirements by the scheduled commercial banks have come down significantly, it is still considered to be high. In the eventuality of a decline in reserve requirements, alternative set of investors, particularly retail investors, need to be put in place well in advance to fund the government borrowings. Gradual move to reduce the upper limit on held-to-maturity (HTM) category of G-Sec holdings by banks has been initiated so as to stimulate the secondary market trading and thereby increase the liquidity of the G- Secs. Catering to the needs of retail investors will contribute to a stable demand for G-Secs, which can cushion the impact of sales from financial institutions and FIIs at times of volatility. Investors' education would go a long way in improving the retail participation. In this context, primary dealers (PDs) also need to make a greater effort to promote the mid-segment investors. L. Lakshmanan and R. Kausaliya, RBI Working Paper, August

4 SUMMARY Fifth, to address the challenges regarding benchmarking and consolidation of issued debt, a policy of reissuance through price based auctions was commenced in Buyback and switch operations also enable the RBI to contain the rollover risk. To improve the liquidity through buildup of critical minimum to trade in the secondary market, measures have been put in place such as effective passive consolidation, increasing the issuance size to a tolerable level, active consolidation such as buybacks and issuance of securities at various maturity points, creating a heterogeneous investors base with different maturities, instruments best suited to the appetite of the market participants, risk preferences, etc., and improvement in market infrastructure. Sixth, investment horizons, risk appetite and needs of the investors in the securities market vary across the spectrum of yield curve. In India, issuances of zero coupon bonds, capital indexed bonds, FRBs, bonds with embedded derivatives (call/ put options) and IIBs were enabled to meet the diversified funding and hedging needs of the market participants. Seventh, towards an efficient market mechanism, a market-oriented government funding strategy is one of the essential features that would improve the secondary market trading. However, the development of a vibrant secondary market for government securities has proved to be a challenging task. To test the extent of influence of liquidity on the bond yield, net liquidity availed by the banking system from RBI has been divided into two phases, viz., the surplus phase from November 2008 to middle of September 2010 and deficit phase thereafter up to February Auction-wise data on maturity, amount raised, weighted average yield, availability of net liquidity on those days of auction, repo rate, MSF rate and weighted average call rate on those days have been used for the period from November 2008 to February According to the observations from the empirical exercise, in case system liquidity is in deficit phase, when a positive shock is given to the net availability of liquidity, bond yields gradually move to the reverse direction in the first four period (four weeks) and thereafter, the yield stabilizes at a level lower than the level before the shock is effected. In this scenario, while a shock to repo rate does not stimulate the yield movements much, however, expected increase in repo rate has immediate positive impact on the yield, which increases immediately and thereafter it reverts and stabilizes at the earlier level. The call rate responds positively and the yield increases slowly and stabilizes at an elevated level. In a surplus liquidity phase, an innovation in liquidity does not impact the yield movement much as the system is already flooded with liquidity. In such a situation, a shock to repo rate has little impact on the yield. However, expected increase in call rate impact the yield significantly and thereafter stabilizes at the earlier level. To study the impact on the yield of different maturities of G-Secs in the primary auctions, the data for the period from November 2008 to February 2014 was segregated according to the residual maturity in three groups, viz., (i) up to 10 years, (ii) above 10 years and up to 20 years and (iii) above 20 years. Shocks to the liquidity, repo and call rates impact the bond yield at the desired direction in the maturity bucket of years securities, whereas yield of securities upto 10 year maturity is impacted by the shock of liquidity and repo rate. For securities having residual maturity of above 20 years, the impact on the yield is significantly low when a shock to the liquidity is effected. This may be due to the fact that the interest on long term investments are being decided mainly by inflation expectations, 14

5 the interest rate scenario and the long term cost of funds. The repo rate has impacted the yield of the G- Secs significantly with all maturities upto 30 years. In case of securities with maturities above 20 years, a shock to call rate impacts the yield after two weeks. In all the three categories of maturity, when a shock is given to the repo rate, the yield responds positively and increases immediately and thereafter stabilizes above the level of the pre-shock period. In addition to repo rate shock, expectation of increase in repo rate also impulse the yield to increase and the same is the case with the call rate. However, when the market expects a decrease in call rate, bond yield for shorter maturities has decreased in anticipation. In a combined liquidity phase (deficit and surplus), the yield does not respond to positive shocks in liquidity. However, the yield responds positively to shocks in marginal standing facility and repo rates. Accordingly, when the rates of repo and MSF are increased, the yield also tends to increase simultaneously. Additional variance decomposition analysis reveals that positive shocks to liquidity impact the yield of the securities with maturities upto 20 years. However, shock to repo rate affects the yield more significantly in all the maturities and the call rate affects the yield of the securities with maturities over 10 years. Overall, though various factors determine the yield of the dated securities of the GoI in the primary auctions, the availability of short term liquidity and the cost of such liquidity also impact the yield significantly. Expected increase in repo rate has significant and immediate impact on the yield. Source: 15

6 SUMMARY Inter-sectoral Linkages in the Indian Economy Analyzing inter-linkages across five major sectors of the macro-economy - the output (GDP/its components), prices (WPI/its components), monetary (money supply and interest rates), fiscal sector (government expenditure and receipts) and the external sector (trade, capital flows and exchange rate), the paper investigated evolving economic structures in India over period. The objective of the paper was to assess model building and policy simulation mainly for monetary policy as monetary policy impulses appear through policy instrument/interest rates affecting the money market rate, which then transmits through a broader spectrum of deposit and lending rates. It also affects credit conditions in terms of deposit and credit growth and the real economy in terms of GDP growth and WPI inflation. The monetary policy variables like money growth and interest rate affect non-food manufacturing inflation at the wholesale level (which was often interpreted as core inflation by monetary authority in India till the very recent period). On the fiscal front, the fiscal condition impacts lending rates by changing the level of private sector borrowing. The impact of credit cost on private investments is also prominent. Performing basic diagnostic checks, the paper conducted empirical analysis across all major sectors -which major findings are presented sector-wise. In monetary sector, currency demand is positively associated with income and negatively associated with the interest rate on deposit reflecting the opportunity cost of holding money. The growth in demand deposit and time deposit are significantly linked with Real GDP growth. However, term deposits are not influenced by returns on equity, latter being an imperfect substitute for banks deposits. It is also found that lower real lending rate or even higher inflation reduces borrowing costs in real terms enabling larger demand for credit. The growth in net bank credit to central government indicates greater impounding of resources by the government reduces the availability for the private sector. Unlike deposit rates, higher inflation rate and fiscal deficit of the centre puts some upward pressure on lending rates in India. In prices sector, the consumer price inflation does not reflect nominal anchoring of monetary policy, while WPI inflation seems to be the relevant price indicator in monetary policy anchoring till very recent period. On WPI food inflation front, growth in private final consumption expenditure on food (on demand side) and minimum support price (MSP) of food (on supply side) seem to be significant determinants in setting a floor for WPI food inflation. Moreover, international food prices are significant, but with smaller magnitude. WPI fuel inflation is largely driven by international crude prices due to higher dependence of India's energy requirement on crude oil. The INR/USD exchange rate also significantly plays role in determination of WPI fuel inflation rate. The WPI non-food inflation is strongly linked with industrial production through trade link. The non-food manufacturing inflation seems to be affected by some measures of aggregate demand. However, output gap does not qualify as significant determinant in the non-food manufacturing inflation. It was found that higher inflation rate reduces government discretionary consumption possible through a rise in committed non-plan expenditure like subsidy, interest burden etc. and leaving less room for adjustments without pushing up fiscal Rajib Das, Binod B. Bhoi, Pankaj Kumar, Krittika Banerjee 16

7 deficit commensurately. Only financial repression emerges as the most prominent determinant of investment in India. The paper found that investment activity in India is explained by real personal disposable income (PDI) growth and is linked with improved cash flow removing financial constraints to household investment. However, inflation perhaps reduces profitability and enhances investment uncertainty of household/smes, and thereby observed to be holding back investment. From the supply-side, variables like growth in total cultivation area, deviation in production-weighted rainfall from its 10-year average rainfall and agricultural credit are important determinant of agricultural output. On demand-side, the growth in real private final consumption expenditure scales up agricultural output as it enables shifts in agricultural output towards high value products. Industrial GDP significantly depends on gross investment, lending rates, global IIP and real exchange rate., global IIP and real exchange rate and cost of borrowing. The real service GDP reflects the impact of real interest rate, real personal disposable income, services exports, and exchange rate besides its own lag and some dummies. It also depends on provision for services by the government especially for community, social and personal services. adjustments is borne by the capital expenditure. Fiscal consolidation coincides with a general fall in inflation and reduction in the cost of borrowing by governments, also aiding to the containment of revenue expenditure. Capital expenditure of the combined government reflects higher sensitivity with respect to growth, while WPI inflation turns out to be insignificant. On external sector front, current account estimate on merchandise (for goods exports and imports) and invisibles (services exports and imports) seem to be very sensitive to exchange rate movements. Capital regulations in debt flows are more prominent in India than that of equity flows. GDP growth facilitates higher demand for debt in India as it imparts greater confidence to overseas investors. The level of inflation is another important determinant of debt flows with higher inflation reducing the expected real cost of borrowing from domestic sources besides enhancing debt cost from abroad on deteriorating exchange rate expectations and vice versa. Higher growth differential (India's GDP growth over the world GDP growth) enhances country's attractiveness to the global investor, domestic equity prices indicates investment climate, and overall growth in net private flows to emerging market countries shows global risk appetite. In the fiscal segment of economy, revenue expenditure remains sticky and hence the burden of Source: 17

Prepared by Basanta K Pradhan & Sangeeta Chakravarty January and February 2013

Prepared by Basanta K Pradhan & Sangeeta Chakravarty January and February 2013 Highlights Sharp fluctuation in Industrial activity Headline inflation is down marginally Marginal rise in CPI inflation Rupee