Momentum supportive of a stronger rupee

The ongoing rally gathered more steam last week as the rupee added to its gains against the US dollar, buoyed by optimism relating to the government’s decision to increase the foreign direct investment (FDI) limit in insurance and pension sectors.  Foreign investor interest in India is up: foreign institutional investors (FIIs) bought $4.1 billion worth of Indian stocks and bonds in September and added almost another $1 billion to their holdings in the first week of October.

Appetite for dollar-denominated bonds issued by Indian companies has also improved since last month. Last quarter, Indian companies sold the most overseas debt in two years. More issuers are tapping global investors after the government slashed a tax on foreign borrowing.

The rupee’s exchange rate has faced the most significant pressure since August last year when global investors and local market participants turned bearish on the prospects of the Indian economy to attract foreign capital. The government’s recent reform initiatives will bear results over the next 12-18 months, in terms of increase in FDI. Investor sentiment towards India has clearly become more optimistic.

A stronger rupee has significant beneficial impact on the overall economy. For one, it attracts greater inflow of capital, helping ease interest rates and reviving investments. For another, a stronger rupee helps in negating the pressure from higher crude oil prices on inflation. That, in turn, gives the RBI some room to ease monetary policy levers.

However, after having appreciated by almost 8% in the last seven successive weeks, further appreciation would be dependent on global investor risk appetite, government initiatives to tackle supply-side bottlenecks to growth and efforts to control fiscal deficit.

Global environment has also been favourable since late August. Risk-sensitive assets have rallied globally on the back of supportive action from the world’s major central banks, easing euro zone sovereign debt tensions and some better US data. A much-anticipated US jobs report supported risk sentiment on Friday as the country’s unemployment rate dropped to 7.8%, a near four-year low.

While the recovery of the US labour market remained fragile, Friday’s employment data combined with the Federal Reserve’s recent measures to boost the economy, would have a positive impact on investor sentiment in the coming months, helping ease fears of a further slowdown in the US economy.

Concerns about the euro zone fiscal crisis have also continued to ease. The euro rallied sharply through September as the European Central Bank (ECB) pledged an unlimited bond-buying programme for at-risk sovereigns.  Spain is most likely to request for an official bailout which represents a very powerful positive fundamental catalyst for risk sentiment and markets. Once Spain accepts an international bailout, the ECB will come into the market and use its new Outright Monetary Transactions to suppress bond yields by buying Spanish government bonds. Lower Spanish yields are bullish for the euro while higher Spanish yields are bearish for the euro. Any signs from the Spanish government towards seeking official support from the ECB and the International Monetary Fund would boost investor risk appetite and will be positive for riskier assets like stocks. That would reflect favourably on the local stock market too.

In the local market, ahead of the inflation and industrial production data due this week and early next week, focus will shift to the RBI to provide monetary support in response to government’s measures to revive investments and curb fiscal deficit. The finance minister has indicated that the reforms push would continue.

Going by the spate of recent announcements, the focus of these measures would be on attracting greater foreign capital inflows. Even though inflation for September is going to print higher than the August reading of 7.55% on account of the fuel price hikes, expectations of a rate cut or a cut in the cash reserve ratio, will therefore continue to build up in the run-up to the half-yearly monetary policy review by the RBI on October 30. This would mean that the market would not react negatively to higher inflation data.

Market momentum is also firmly behind the rupee now. With the US dollar losing ground overseas, the Indian unit can extend its gains, especially if the government continues to announce measures to spur growth. In fact, even administrative measures aimed at improving governance will go down positively with market participants.

This week, the rupee-dollar pair will likely trade in the range of 51.00-52.00.

The author is senior economist at the Royal Bank of Scotland NV. Views expressed here are his own.
gaurav.kapur@rbs.com