Many investors who hold foreign currency -- let us take the US Dollar in this case -- worry a lot about the 'exchange rate' at which they will get to transfer their proceeds into India and back. What they should, however, be looking at is whether all this 'worry' is worth it, i.e. does the exchange rate actually have a significant impact on the overall returns.

Before we look ahead, let's look into the past to understand how significant has been the impact of the exchange rate (Indian Rupee/US Dollar).

If we take the period starting December 1998 (which is about five months after Russia defaulted on its international debt repayments; the Asian crisis started with Thailand's currency losing its value significantly in July 1997), the Indian Rupee has oscillated quite a bit, but within what is apparently a band of Rs 42.49 per US Dollar and Rs 49.05 per US Dollar.

From point-to-point (December 1998 to September 2006), however, the depreciation in the value of the Indian Rupee vis-�-vis the US Dollar is just, hold your breath, 1.0% per annum (p.a.)! In the same period, the Indian stock markets, represented by the BSE Sensex, returned 18.9% CAGR (compounded annual growth rate). In effect, the impact on returns was an insignificant 5.1%!

Within this period of nearly eight years there are two distinct phases. The first phase, between December 1998 and May 2002, saw the Indian Rupee depreciate by 4.3% per annum. This phase saw a very unstable global environment marked by the Asian crises, the Technology-Media-Telecom (TMT) bubble and the Y2K issue.

During this period, the Sensex yielded a return of 11.5% CAGR. The impact on a foreign investor was a very significant 7.2%, i.e. your return would stand reduced significantly to 7.2% on account on the depreciation in the value of the Indian Rupee.

In the second phase, between May 2002 and September 2006, the Indian Rupee actually appreciated against the US Dollar at an annualised rate of 1.5%.

In this period, where the overall global environment was very bullish and the premium for risk had reduced dramatically, the BSE Sensex returned 26.9% CAGR in Indian Rupee terms; in terms of US Dollars therefore the gain was higher at 28.4%!

What the graph then tells us is that over a longer period of time, the currency impact has been negligible. However, in shorter time periods you could have either gained or lost depending on the timing of your entry/exit.

So, should you pay little heed to the exchange rate when you are investing in India? Let's first list out the key factors that support this view:

One, if the view is that India is likely to grow at over 8.0% p.a. for the foreseeable future and continues to open up the economy from an investment perspective, then the flow of funds from abroad, be it FDI (foreign direct investment -- broadly investment in real assets) or FII (foreign institutional investor -- money goes into buying securities) will continue to be buoyant.

So far, the FII money has dominated the inflows; over time FDI, which is more stable, relatively more predictable, will also pick up. The inflow of funds, will lend support to the value of the Indian Rupee (the foreign investor will exchange his Dollars for the Indian Rupee, thereby driving up the demand, and therefore all else being the same, the value of the Indian Rupee will rise).

Two, growing exports (of both services and manufactured products) coupled with mobilisation of funds from the international markets by Indian companies and remittances by Indians abroad (in China, remittances from overseas Chinese is a big contributor to overall foreign currency inflows) should add to foreign inflows, which again will provide support for the Indian Rupee.

While exports will benefit predominantly from cost competitiveness, the investment opportunity in India will see Indians remit increasingly large sums of money to India.

Finally, over the long-term, a stronger economy should result in a stronger currency.

From what is apparent today, the American economy is slowing down (not to mention that it suffers from critical structural issues including excesses in the real estate market which in recent years has been a key driver of consumption and a burgeoning current account deficit), while India finally seems to have achieved a higher growth trajectory of 8.0% pa or thereabouts (being realistic, we will disregard talk of 10.0% pa growth).

Over time, as the US economy corrects the excesses and the Indian economy gathers momentum, the relative strength of the Indian currency vis-�-vis the US Dollar should improve.

Why a relatively stronger Indian Rupee may not be a reality?

1. First, the eight-year period that has been considered for the study in itself may be too short. If the time period under study is doubled (starting January 1990), then the rate of depreciation of the Indian Rupee vis-�-vis the US Dollar increases dramatically to 6.5% pa. The interest of the global investment community in emerging markets goes through phases.

The reversal in interest, as and when it comes, can often be painful. In present times, there is little risk premium attached to investing in the emerging markets, which simply put, is more a result of too much money flowing in emerging markets rather than a change in the fundamental 'volatile' nature of emerging markets.

As and when the risk premium reverts to the mean, the 'correction' in asset values and also the currency can be significant.

2. Second, even though studies have indicated that the Indian economy has grown irrespective of which political party is in power, it cannot be overstated that many a times the policy initiatives of the government are driven by factors which are other than economic.

Of course, there is more or less a unanimous opinion that the reform process is irreversible. In fact, slow as it may be, the process is chugging along. But concerns remain about proposed policy measures, including job reservation in the private sector.

Then of course, the biggest risk that India runs today is that its coalition government (single party governments do not seem a reality well into the future as of now) will not rise to the occasion and create an environment (read policy framework, infrastructure) where all this feel good about India will translate into actual money flows and therefore growth.

This failure is not without a precedent. This will impact the long-term attractiveness of India as an investment destination.

3. Third, in recent years even as oil prices have risen sharply, the impact on the Indian economy has been surprisingly muted. The reasons are not far to seek. Steady foreign inflows (both FII money and export proceeds) have helped India fund the import of this commodity which now accounts for about 40% of all imports.

4. Then, of course, the government has not permitted the complete pass through of the rise in crude price to the consumer; while a part of this burden has been borne by the government, oil marketing companies too have had to share the losses.

5. Finally, due to some clever accounting jugglery, this 'deficit' which the government has to bear is no longer part of the union budget i.e. the fiscal deficit no longer includes the losses incurred by the government on 'subsidising' prices of petroleum products.

The result is that finances of the central government appear better than they actually are. Historically, a rise in prices of crude oil used to create a flutter; now we are almost indifferent.

However, ultimately someone will have to foot the bill for this subsidy; but in case the price impact is passed through to the consumer, the impact on economic growth too would be felt. This would result in a toning down of near to mid term expectations of domestic growth.

So what should you do?

In our view, the best approach would be to allocate money to India depending on two factors:

a. Your needs which involve an expenditure in Indian Rupees: So if you are planning to retire here or you need to provide for your dependents in India, it is best that you do not pay much heed to the exchange rate and start to transfer funds to India.

b. The extent to which you are comfortable with the depreciation of the Rupee: If you are contemplating investing in India, it would be advisable to factor in a 3% annual depreciation of the value of the Rupee vis-�-vis the US Dollar. The current feel good environment may not last long and it is best that your investments are based on realistic assumptions.

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