Reforms, QE3 to turbocharge the rupee

The US Federal Reserve’s much-awaited third round of quantitative easing (QE3) sparked a sharp rally in riskier and growth-oriented assets across the board last week. Global stocks extended gains while fixed-income assets were sold off. The US dollar plunged to its lowest against both the euro in 11 months and the yen in seven months. Japan signalled it is ready to intervene to stem the yen’s strength.

The Indian rupee gained by 2% against the US dollar, further buoyed by the government’s decision to raise fuel prices. Both the equities market and the rupee will likely continue to rise this week on the back of Friday’s economic reforms relating to foreign direct investment (FDI) and disinvestment.

With major central banks across the globe looking to provide more monetary stimulus, the timing and the manner of the Indian government’s announcements are bound to provide a significant boost to market sentiment and businesses alike. These reforms are very crucial to kick-start growth and tackle the supply side bottlenecks.

FDI benefits will accrue over a period of time, not this fiscal. For example, in case of multi-brand retail FDI,  foreign investors would wait for the political backdrop to clear and stabilise before they commit any large investments. Similarly, fiscal consolidation may not help much in narrowing budget deficit.

But reforms will buy the government some time with international ratings agencies. S&P and Fitch recently put India’s sovereign rating on a “negative” watch list for a possible downgrade to junk status. The government has only about 6-9 months to avoid a rating downgrade. First and foremost, this requires a firm handle on rising fuel subsidies bill.

The government’s new-found resolve will help the Reserve Bank of India (RBI) to cut rates and provide some monetary stimulus. Any such moves will be positive for stocks and the rupee. It is possible the RBI could announce some liquidity easing measures if not a rate cut today.

This week offers few event risks and could potentially lower volatility seen this month. Market participants would keep an eye on a number of speeches by Fed officials due this week. The announcement of bond-buying by the Fed has left most puzzled as officials committed to an open-ended buying of $40 billion of mortgaged-backed securities per month. This is different from QE1 and QE2 when the Fed announced a target for bond purchases, and markets knew how much stimulus was being provided.

In his post-event news conference, Fed chairman Ben Bernanke was very vague on what improvement in the labour market would warrant an end to money printing. This essentially leaves predictions for the future of QE dependent on every single economic data point related to the labour market in the near future.

A material improvement in the European financial market conditions has also hurt the outlook for the safe-haven greenback. Continued calm could push it to fresh lows across the board. It will, therefore, take a significant wave of risk-aversion to help the US dollar recover from the recent round of debasement.

Continuing weakness in the greenback, combined with the euphoria created by the Indian government’s reform measures last week, can propel the rupee-dollar pair towards the 53.00 level. However, markets would be keen to know if political pressure applied by allies and opposition alike would force the government to roll back any of its latest reforms. Any roll-back could see stocks and the rupee suffer some losses.

The writer is senior economist at the Royal Bank of Scotland NV. Views expressed here are his own.
E-mail: gaurav.kapur@rbs.com