Weak risk appetite may offset any RBI support for rupee

Risk appetite in the financial markets remained weak last week on disappointing US corporate results, record unemployment in Spain and unexpected fall in German business confidence.

Also, concerns that the three-year old euro zone debt crisis may worsen increased, after German finance minister Wolfgang Schaeuble said there are doubts about whether Greece, where the crisis began, has met its commitments for an international bailout. Better-than-expected US GDP data helped limit the losses in growth-sensitive risky assets.

In the global currency market, the US dollar gained against the euro as the US Federal Reserve maintained asset-purchase programs without suggesting it is closer to boosting stimulus, reducing concerns that additional measures will debase the greenback. The Fed said in a statement after a two-day policy meeting last week that the US economy is still growing modestly and unemployment remains elevated. The Fed maintained a pledge to hold the key interest rate at virtually zero until at least mid-2015.

The euro depreciated against the US dollar over the week on rising unemployment in Spain, weakening business confidence in Germany and as data showed services and manufacturing in the Euro-zone contracted more than anticipated in October.

The Indian rupee gained by 0.5% in a holiday-shortened week, as foreign institutional investor (FII) inflows picked up and oil prices eased during the week. FIIs were net buyers of local stocks and bonds last week, adding $625 million worth of assets to their holdings. A successful auction of the FII limit for government and corporate bonds also helped boost the local unit. Over the week, the rupee-dollar pair traded in the range of 53.34-54.00.

This week, there is plenty of US data for the market to focus on. On the economic calendar, consumer confidence, manufacturing activity and personal spending reports can offer only minor adjustments to views about the world’s largest economy. The most important in terms of risk appetite drivers is the October non-farm payrolls report.

Beyond data, there are important issues which can affect the confidence of investors the world over.

The fiscal cliff in the US is 2013 – one of those high-level concerns and the primary reason market participants would watch the US elections. The most urgent and overwhelming risk remains the euro area crisis.

Spain is yet to ask for an official rescue despite a stretched budget and a weak banking system. Greece is trying to meet the onerous conditions creditors have imposed on it for further support. If either of these countries moves towards getting the official support, risk appetite will improve. At the same time, if things drag, particularly in Spain, investors and market participants will become increasingly nervous about the euro zone crisis.

In India, all eyes will also be on the half-yearly review of the RBI’s monetary policy tomorrow. The RBI is faced with a macroeconomic environment characterised by high and rising benchmark wholesale inflation, stabilising growth momentum with signs that economic activity has bottomed, a stable-yet-weak currency, easing commodity prices and slowing global growth. Although this macro backdrop has been in place for a while, there is a key difference this time round. The government’s policy activism since mid-September has replaced policy stasis, prompting the RBI to maintain a tight handle on monetary levers.

While higher inflation will remain the main constraint for the RBI in providing any monetary stimulus, growth falling well below its trend rate (7-7.5%) is unlikely to be ignored completely. More so because of the global economic slowdown which can prolong well into 2013.

In tomorrow’s policy review, the RBI is likely to lower its assessment of GDP  growth to closer to 6% than 6.5% now. Therefore, to help revive growth and complement the government’s policy measures, the RBI may take a calculated risk and cut the repo rate by 25 basis points (bps). The consensus view, however, is a 25 bps cut in the bank’s cash reserve ratio.

If the RBI cuts the repo rate or softens its tight policy stance, the rupee would gain. Higher interest rates have had an adverse impact on consumption and, to some extent, on investment. Therefore, any softening in rates would help support a recovery in growth and sustain the positive sentiment around the economy and corporate earnings. This will be positive for stocks and the rupee.

Overall, the rupee will continue to trade with a moderate weakening bias, unless global risk appetite improves. The rupee-dollar pair will trade in the range of 52.75-53.75 this week.

The writer is senior economist at the Royal Bank of Scotland NV.

Views expressed here are his own. E-mail: gaurav.kapur@rbs.com