Reckless rupee strangles ADR premia

CHENNAI: As the US dollar faltered in the recent quarters and Indian economy continued its growth momentum, one trend kept itself away from public glare: shrinking ADR premia.

The huge premia that Indian ADRs enjoyed over the underlying Indian stocks have shrunk, and in some cases disappeared. A couple of scrips are trading at discount. The narrowed gap is thanks to many factors, including improved liquidity, growing investment options and changing perceptions about India, according to observers.

Earlier, huge premia were the norm among exchange-traded Indian ADRs. Five years ago, Infosys ADR traded at 57% premium compared to underlying Indian shares. Today, the premium is less than 3%. ICICI Bank’s was over 11%. Now, it’s trading at a discount.

IT sector ADRs were trading at an average premium of 27.8% for six years till August 2006, with Infosys trading at 44.5% premium, Satyam 20.9% and Wipro 18.1%. Finance companies had a premium of 11%, (ICICI Bank 11.2% and Satyam 10.9%), according to a paper in Icra Bulletin, a journal published by the credit rating agency.

“Among exchange-traded Indian ADRs, IT companies enjoy the maximum premium followed by the banks while others have much lower premia. However, the premia have dropped across sectors in the last couple of years,” Rajesh Chakrabarti, Indian School of Business, Hyderabad said.

Since ADRs just represent underlying local shares, there should not be any price differences — in an efficient market. But factors such as smaller number of ADRs, regulatory issues and relative discomfort with Indian markets explained the premia. However, dynamics surrounding these factors have changed, leading to shrinking ADR premia, observers said.

Firstly, American investors have become more comfortable investing directly in India than they were earlier. “India has matured from an exotic to a mainstream market for international investors, with many investment houses setting up research teams and funds for India,” said Franklin Templeton senior portfolio manager-equity Sivasubramanian KN.

A couple of years ago, investors chose ADRs because they wanted to participate in India’s growth story. Yet, they were not comfortable in dealing directly in the Indian market. And so, they were willing to pay a premium to get both, said Spark Capital ED and head-investment banking K Ramakrishnan.

With their willingness to enter India directly, premia have been shrinking. Besides, the currency risk faced by those who wanted to invest directly in India has turned the other way round. “Today, US dollar looks riskier than INR. So, an investor is better off investing directly in India,” Mr Ramakrishnan said.

In other words, a foreign investor who invests in rising Indian markets at a time when dollar is depreciating, can get double benefit of returns on that investment as well as rupee appreciation. Market for ADRs has become more liquid on the back of further issues by Indian companies.

The premium that Infosys ADRs commanded considerably dropped after the number of ADRs went up, following their subsequent issue. “Improved liquidity or availability is definitely one of the reasons for the premia to drop substantially,” added Mr Sivasubramanian.

Investment options for US investors have gone up. Kellogg School of Management professor and founder of Great Lakes Institute of Management Bala V Balachandran said, “The demand for ADRs has decreased because of alternate funding avenues. You now have PEs, hedge funds and options who are eating the same pie that ADRs enjoyed at one time.”

Mr Chakrabarti pointed out that while FCCBs and Depository Receipts (the number of 20 million plus issues) almost quadrupled from an annual average of roughly 650 for the past several years to 2,552 in 2005-06. “So clearly, Indian paper has become more available in foreign markets, though not the number of exchange-traded ADRs,” he said.

The lower premia is also a result of booming Indian stock market, and relatively under performing US markets. Mr Chakrabarti said, “A curious thing about ADRs is that their movements are more strongly related to the US markets rather than Indian markets.”

The connection between ADRs and US markets has another implication at a time when the US economy and its stock markets are facing the pressure of subprime crisis. Mr Sivasubramanian said, “The recent rise in risk aversion due to the subprime concerns has also resulted in the premia vanishing in many cases.”