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Risk appetite improved sharply last week amidst hopes of some progress in the euro zone crisis, strong US data and proactive action from global central banks. Led by the Federal Reserve, six central banks slashed the cost of dollar liquidity for banks, easing fears of a credit crunch. The Chinese central bank cut its reserve requirement ratio for the first time since 2008. These started a rally.

Global equity markets had their best week in three years amid hopes of a resolution to the euro zone debt crisis. Hopes of a grand bargain between euro-zone governments and the European Central Bank (ECB) boosted risk appetite. A speech by Angela Merkel, Germany’s chancellor, supporting ‘fiscal union’ for the euro-zone, together with hints from Mario Draghi, ECB president, that the central bank might be prepared to act, fuelled the rally.

Riskier assets rallied again on Friday after the unexpected decline in US unemployment rate to its lowest level since March 2009. US jobs data showed the unemployment rate in the world’s largest economy fell to 8.6% in November. The news on the US employment market came on the back of other positive US data last week. Surveys of manufacturing activity by the Chicago Fed and the Institute for Supply Management had both pointed to the strongest growth for months.

Inthe global currency markets, the euro ended the week higher than it started against the US dollar for the first time since October, amid a marked improvement in risk appetite across global markets. The single currency hit a high for the week on Friday, though it fell slightly in late trading as market participants took profits. The euro rose 1.2% against the greenback over the week. The 17-nation currency also strengthened 1.5% versus the yen.

Currencies of commodity exporting countries gained sharply from improvement in risk appetite. Australian dollar climbed 5.2% against the US dollar last week as the S&P 500 Index of stocks gained 7.4% and the S&P GSCI index of 24 raw materials rose 3.5%.

Asian currencies also completed their first weekly advance since October after joint efforts by monetary authorities to tackle Europe’s debt crisis bolstered sentiment toward higher-yielding assets. The South Korean won strengthened 2.9% against the greenback. Malaysia’s ringgit climbed 2.6% while Thailand’s baht jumped 2%. In the local inter-bank market, the rupee also appreciated by 2% helped by a rally in the stock market.

The BSE Sensex rose 7.3% over the week on the back of some buying by the FIIs. Portfolio players also bid aggressively in the auction for government debt, indicating their appetite for local bonds to take advantage of high interest rate differentials. Local market participants sold dollars, noting the weakness in the greenback globally. Opposition to the government’s move to open up the retail sector for FDI was ignored.

Over the week, the rupee-dollar pair traded in the range of 51.1975 - 52.428.

Looking ahead, US and global economic growth is decelerating, global financial markets are starting to worry about a credit crunch and a dollar liquidity squeeze as was seen in 2008. Market participants are coming to terms with the reality that the unwinding of excessive leverage (for investors, consumers and governments) is going to take a fairly long time. In turn, the tone across the financial markets is one of fear and caution. There is a however, hope that governments and policy makers would repeat their actions of 2008 and provide support to the financial system and the banking sector.

Market participants and investors are holding back on taking risks. The greatest threat is the health of progress of euro zone crisis. Officials have bought themselves time by promising possible big changes at the December 9 EU summit.French and Germany leaders are expected to announce some proposals. If they are uninspiring, fear could sweep over. Otherwise, standard macro-economic data releases will provide only short-term volatility.

Any squeeze in investor risk appetite could mean a drop in the stock market and the rupee. Developments over the FDI in retail could prove to be negative for the rupee, as they reinforce fears of policy inertia. Any durable solution to the euro zone crisis is going to help the stock market and rupee. Over the week, the rupee could still trade with a depreciation bias, considering the oil prices are rising again. The rupee-dollar pair can trade in the range of 51.00 - 52.50 over the week.

The writer is senior economist, Royal Bank of Scotland NV, and can be reached at gaurav.kapur@rbs.com.

Views expressed herein are personal