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Weak Rupee To Boost Export, Import Substitution: Credit Suisse

Posted on October 4, 2012 in Business and Economy

About the column: In our column “Bull’s Eye“, we take up articles from business dailies like Economic times and Business Standard, and explain them. In each article, we cover an economic/financial concept and a market occurring that the article is focused around; and explain it in the context of that news update.To read more from the column, click here.

By Naman Sanghvi & Sangeet Agarwal:

Link to Original Article

Original Article:

Fall in rupee is likely to bring opportunities for the domestic economy by boosting exports and substitution of import in the near future, a Credit Suisse report said.

“We believe India’s trade should start to change now as the economy re-anchors…the fillip to inflation and subsidies have already been felt, the opportunities though will be more visible over the next 18-24 months as companies generally hedge and it takes time for supply chains to reconfigure,” the report said.

As many companies would have hedged, the changes in exchange values will not affect them; but with reflect in recent and newer deals which will be reflected a couple of months into the future.

Giving an estimate of opportunities, the research report said around $ 60 billion of exports can be increased due to weak rupee, while $ 60 billion of import can be substituted.

“We estimate about $ 60 bn of imports can be substituted and $ 60 bn of exports could see a boost,” the report said.

Indian rupee is now hovering around $ 55 level which is likely to make exports from the country competitive with substitution of imports due to expensive imports.

Referring to import substitution, the report said the opportunities for substitution exist only in those areas where domestic manufacturer can’t compete on cost.

“The rupee being down by a fourth against the dollar over the past twelve months should create opportunities…either by allowing for immediate substitution or, in a smaller way, by accelerating the set-up of new capacity. In particular, we focus on the $ 61 bn of imports where the primary reason is cost,” it said.

“We believe categories like diesel gensets, textile-related machinery, household appliances, furniture, tyres, penicillin/cephalosporin intermediate manufacturers and sectors aligned to the growing of pulses and oilseeds are potential beneficiaries of import substitution,” it added.

Similarly, the report also said exports will get benefitted due to competitive advantage, low cost of labour and weak rupee.

As per the report, sectors like auto and auto components, agriculture, bulk drug exporters, jewellery and service exports will be benefitted from the weak rupee.


Currency effect on trade

Fluctuation in currency of any country has a major impact on the trade that a particular nation does with other economies of the world. The trade being, the import and export of goods or services. The rise of currency of one nation with respect to its trading partner will benefit the first if he buys products from latter and benefit the latter if he sells to the first. So the fall in rupee in recent times can be added to India’s advantage if we start boosting exports by substituting imports. And as per the recent Credit Suisse report this seems to be a likely strategy that Indian economy will experience in near future.

Import — Export

An exchange rate is the value of one currency in terms of another. So when we say INR 55 = 1 US$, it implies that 55 INR can be traded for 1 US Dollar.

All countries trade a variety of commodities and exchange rate is relevant here. An Indian manufacturer produces a certain type of goods and sells it at 5500 INR. If an American was to buy this product he/she would pay 100 USD for this (assuming perfect conversion with no taxes).

If the exchange rate changes and become INR 60 = 1 USD; then for the good offered at a price of INR 5500, the American will pay 91.67 USD (1 INR = 1/60 USD). Thus it is cheaper for an American to buy the good and he would prefer to buy this- i.e., demand more; and increase exports.

Likewise say an Indian was buying an American product priced at 50 USD, and then originally when the exchange rate was 55 INR, he was paying 550 INR for the product. Now at the new exchange rate he would be paying 60 INR. Hence he would look for an alternate product that is cheaper yet of the same quality and thus demand for the American product would go down, implying imports go down.

Now a fall in the Indian rupee, meaning a fall in the value of the Indian rupee with respect to the US dollar thus seems to increase exports and curb imports. (The example was that of a Dollar, but holds good for other countries and currencies too). Terminology wise, a fall in rupee value to a dollar (e.g. in above case from INR 55 to INR 50) is called appreciation of the rupee value whilst a rise in the rupee value to a dollar (e.g. in the above case from INR 55 to INR 60) is called depreciation of the rupee value

Why the effect will not be visible in recent times? What is Hedging? What is its relevance in international trade?

The effect of the change brought about by the variation in the value of the currency will not be immediately seen and will be felt only after a couple of months.

In foreign / international trade, companies ‘hedge’ their business transactions / dealing. Hedging means covering the risk exposure due to prevailing fluctuation in the open foreign exchange market. In simple terms, hedging is covering the financial risk of the transaction arising out of the trade.

For example, assume Company A (in India) buys goods worth 100$ from Company B (in USA). Consider the Indian Company A has to pay this transaction value of 100$ after it receive the goods which may be after 10-15days. Now, since the currency of INR / US $ gets traded and changes value every day, Company A decides to hedge this transaction for a fixed exchange rate. It will approach a bank or financial institution or any authorized dealer(s) for conduct this hedging transaction. This means that Company A will block a rate (of US$) as of today, payable on the agreed future date. It also means that Company A is immune for any change in exchange rate between from the date of hedge until the actual payment is done. For doing so, Company A has to pay a premium or a charge to the bank / financial institution / authorized dealer. In fact the bank/ financial institution would make revenues through providing such services, and they based on their market intelligence will also take further positions/ further trade/ further hedging. (Hedging is a complicated science and this is a very basic example based on multiple assumptions to simply explain the concept).In today’s world, foreign exchange market is too volatile and riskier. Therefore, hedging has become a perennial and imperative part of any financial department.

Import Substitution

India like any other country is characterized by imports and exports. Import Substitution is a common term used in economics. Import substitution is when a country reduces its imports i.e., dependence on foreign goods through local production specifically for local consumption. Import substitution is seen as a necessary and positive tool depicting growth in an economy.

The rise in imports is attributed to various factors of which the most important ones are — lack of availability, incapability, lack of cost competitiveness (making it cheaper to buy from outside rather than produce locally) and lack of capacity. As per the Credit Suisse report, on account of the rupee devaluing major opportunities for import substitution exists for sectors which are now cost competitive — i.e., local products can compete with those in the global market, as the effective import cost has increased, thus making it more expensive to import. As explained above, the product that was available via import for INR 550 (when USD $ was at INR 55) will now cost INR 600 (assuming the rupee depreciates to INR 60 / 1S). This gives the Indian / indigenous manufacturers / traders, in the similar product segment more cost advantage as their product (similar / competitive) gets cheaper.

Cheap labour and cost competitive sectors likely to drive exports-

Exporting from India has so much advantage that Japan’s 2nd largest automotive giant — Nissan currently ships 85% of its total production from its plant in Chennai to Europe and various other emerging nations.

Depreciating local currency, benefits an exporter and foreign manufacturers who would manufacture in India. A foreign auto company will benefit from the depreciating rupee, because it is now able to get cheaper labour and services at the same price (in foreign currency) which also allows it to earn more in exports.-Foreign manufactures / foreign investors, will now get more INR on every dollar invested in India. This will further encourage more investments and capital inflow in the economy as well.