Decoding the correlation between currency value and stock market movement
You would have often seen the Nifty reacting violently to sharp movements in the rupee value. What is this linkage over the long term? Is the relationship more pronounced in the short term? These are some of the questions we shall look at. First, why does the rupee shift impact the Nifty?
Rupee shifts and impact on the Nifty
If you look at specific periods of rupee volatility like the rupee crisis of 2013 or the crash in the rupee in 2018, the Nifty weakened in tandem with the rupee. Why is there a relationship between the stock market and the rupee value?
Rupee value is a key determinant of FPI flows and these FPI flows tend to become negative when the rupee is weakening or is expected to weaken. That has a negative impact on the stock market indices too.
India still runs an average monthly trade deficit of $15 billion with ~80% dependence on oil imports. A weak rupee puts pressure on the trade deficit and that impairs external ratings of sovereign debt.
Weak dollar puts pressure on corporates that have dollar debt either in the form of ECBs or FCCBs. Weak rupee either adds to the hedging costs of these borrowers or puts them at financial risk if the exposure is un-hedged.
Lastly, the rupee value has a major impact on monetary policy. A strong rupee gives the RBI the leeway to cut rates (since rate cuts tend to weaken the rupee). However, if the rupee remains weak, RBI may hesitate to cut rates, keeping cost of funds high.
Currency versus stock markets in the short run
How does the currency movement impact the stock market in the short run? We can consider the last one year data as a proxy for the short term impact.
Instead of the normal USDINR chart, we have used the INR/USD chart to avoid using a reverse scale. There are two ways to look at the above chart. Firstly, you look at the 1 year returns of the Nifty and the INRUSD and both have weakened. But, that may not tell the full story. If you observe the chart movement, it is clear that the weakening of the rupee between September 2018 and November 2018 has been matched by negative returns on the Nifty. The subsequent bounce in the rupee has also been matched by the bounce in the Nifty. In the short run, the currency and stock market are positively correlated.
What about the longer term relationship between currency and stock markets?
Over a longer time frame, the Indian rupee has generally followed a weakening pattern. That is due to the inflation differential between India and the US. The Real Effective Exchange Rate (REER) is based on the premise that in order to remain competitive, the INR has to weaken to the extent of the inflation differential. Let us leave out the temporary spikes and cracks in the INR and look at how currency and stock markets interplayed over a 5 year period.
Chart Source: Bloomberg
The relationship between the rupee value and the Nifty is largely unrelated over the longer term. If you look at the last five years, the rupee has actually depreciated by (-14.2%) while the Nifty is up by 42%. What explains this sharp divergence between the rupee and the stock markets over the 5 year horizon? There are 3 explanations for the same. Firstly, the gradual weakening of the rupee keeps the exports competitive and the imports under check. Secondly, global investors do factor in a degree of currency loss in EMs and till that point it is the fundamentals of the companies that matter. Lastly, the rupee has been a resilient currency due to regular intervention by the RBI. This entices global investors to buy into rupee weakness, automatically rectifying the balance.
Of course, in the short term, the positive correlation between the fall in the rupee and the fall in the Nifty will continue to hold!