Will a falling rupee really help IT stocks?

No prizes for guessing the sector that is expected to gain the most from a steep fall in the rupee’s value against the greenback.

Yes, it’s information technology (IT).

The rupee’s gyrations have naturally led investors to bet on technology stocks, with the result that the IT index has only slipped 0.8 percent, while the Sensex has tumbled 5 percent over the past month.

A large proportion of the outperformance can be attributed to the currency’s fall: the rupee is currently trading at 52.07 against the dollar after touching an all-time low of 52.73 yesterday. The currency has dived more than 16 percent from the level it was trading at in August (44 to the dollar).

IT companies like TCS, Infosys, HCL Tech, Cognizant and Wipro export software services and earn their revenues in dollars. So, the gain in the value of the dollar is an advantage to them.Of course, they also spend significantly on salaries and other perks in dollars, so to some extent, the impact of changes in the rupee-dollar value is neutralised.

The remaining difference in dollar expenses and revenues is then hedged.

Hedging limits losses - and gains

Basically, hedging is an investment made to reduce the risk of adverse price movements in a security by taking an offsetting, or opposite, position in a related security. For example, if you invest in a fund that will gain due to an appreciating rupee, your ‘offsetting’ hedge is investing in a fund that gains because of an appreciating dollar.

Almost all IT companies engage in hedging.Infosys, for instance, has hedged over $700 million at 49 to the dollar. So, it won’t be gaining hugely from the sudden depreciation in the rupee. An opinion piece in_ Mint _said the sharp fall in the rupee will provide a margin buffer to IT companies.The increase in profitability can be used to offset wage hike pressures, and for marketing to boost demand, it claimed.

That seems logical, but if that were the case, why did Infosys, one of India’s top software service exporters, warn that it might be unable to meet its revenue guidance? Infosys had earlier issued a guidance of 17-19 percent growth in dollar revenues for the year ending March 2012. For the third quarter, the guidance for revenue growth was issued at 3.2-5.4 percent, while the implied guidance for the fourth quarter was 3.3-5.6 percent.

Those estimates, however, sounded over-optimistic given the slowdown in the economy and execution issues with the company. Now the management has said they will meet only the lower end of their revenue outlook because the decision-making process among clients had slowed down.

Two points to be noted here: one is that hedging ensures that IT companies do not get the full benefit of a fall in the rupee and two, volatility in currencies affect a company’s pricing capabilities.

IT is more than just currency gains

Indeed, currencies are also not the only determinant of profits for IT companies.As Pratibha Advani, CFO, NIIT Tech, told_ Economic Times _, “We must also remember, that we are in the business of IT, and not treasury. Little forex gains are less important. A stable economy is necessary for businesses to flourish.”

Complicating the current situation is the fact that the dollar is gaining against other currencies.

The volatility in currencies is actually a bigger headache than a one-sided currency move because it affects the ability of IT company officials to take good pricing decisions. For instance, a foreign client might demand a reduction in foreign currency prices arguing that the rupee’s fall would anyway hand them currency gains.

An Indian company might agree to that but the deal is not without risks. After all, the situation could reverse soon enough: the rupee could start appreciating and then, the client might not agree so readily to a price hike.

In conclusion,while the depreciation in the currency could throw up some short-term gains for IT stocks, the more important point to remember is that the business environment outlook still remains muddied. If stability is not restored, these temporary gains could very well be reversed.