InvestorQ : Why do the currency and the Nifty behave differently in the short term versus the long term and what could be the implications?
Swati Naik made post

Why do the currency and the Nifty behave differently in the short term versus the long term and what could be the implications?

Priyanka Jain answered.
3 years ago

Nifty is surely dependent on the INR but that is not the only factor. Other factors like the inflation, corporate results, oil prices etc also impact the Nifty. In fact, over a period of time a gradual weakening of the rupee has been positive for the Nifty because it keeps exports competitive. Nifty is not overly dependent on the INR/USD currency over the longer term. Here are 3 key reasons why the currency and the Nifty have diverged over a longer period of time.

If you look at the weightage of the Nifty, the biggest weightage belongs to banking, which is not exactly impacted by the INR/USD movements in a big way. It is more vulnerable to rate movements rather than movements in the currency. Among the key sectors there are heavy weights like Information Technology and pharma as well as small sectors like auto ancillaries that actually benefit from a weak rupee. These 3 sectors are export-driven sectors and exports tend to benefit from a weak rupee. That is because a weak rupee makes the Indian products cheaper for the foreign customer as they can buy more with the same amount of dollars. There are other sectors like oil, capital goods, autos and metals that benefit from a strong rupee. But the bottom-line is that there are enough companies in the Nifty that benefit from a strong rupee as also from a weak rupee.

The linkage between the INR/USD equations was brought out by the FII activity in equity markets. FII activity impacts the equity market and the currency market and that used to be the link. But two subtle shifts have happened in the last few years. Firstly, with the government permitting FIIs to invest in sovereign and corporate debt in a big way, many FIIs prefer to take the debt route while underplaying the equity route. The demand for Indian debt is driven by the yield spread between the US benchmark and the Indian benchmark. Secondly, domestic mutual funds have become a potent force and have been infusing over $10 billion into equities each year. This has also weakened the relationship between the Nifty and the INR/USD movement. The domestic commitment is likely to continue due to nearly $1.2 billion of SIPs coming in each month into equity funds.

Lastly, India has managed to put its macros in order through a fiscal discipline focus under the current government. Of course, this has faltered in the last two years but it is still under control. As a result, FDI inflows have picked up sharply and today India attracts more FDI annually than China. Therefore, India’s USD/INR is not overly dependent on the FII flows alone, which has reduced the correlation between the currency and the Nifty. That is why the Nifty and the rupee tend to actually diverge in the long run. It is more because the market accepts some level of rupee depreciation as a given constant in the financial markets.