Column

In the backdrop of concerns over a credit market crunch, further subprime mortgages-related writedowns by large investment banks and prospects of rising inflation, investors continued to avoid risk.

This kept global equity markets under pressure last week and triggered an unwinding of carry trades. That in turn helped the Japanese yen record some more gains. The US dollar also received a boost from this mood of risk aversion and recorded small gains, despite some weak economic data.

In the local inter-bank market, the rupee traded in a relatively narrow range of 39.27 — 39.445 against the greenback and finished the week unchanged in value. The Indian unit was under some pressure during the first two days of the week. The dollar’s strength overseas and a decline in the local stock market put the rupee under some pressure. However, a sharp equities rally on Wednesday boosted market sentiment and helped the rupee recover.

Capital inflows during the week remained relatively tepid. The FIIs brought in a net $201 million to buy stocks and bonds. They, however, remain net sellers in November after some hefty buying in October. The RBI continued to defend the rupee-dollar rate level of 39.30 through its market intervention.

In the international market last week, the pound underperformed its major currency peers while the yen was the outperformer. Sterling slumped as the Bank of England (BoE) laid the ground for interest rate cuts. Mervyn King, governor of the BOE, warned that growth in the UK economy would slow down sharply next year on the back of the ongoing credit squeeze.

The warning came on Wednesday after the BoE released its quarterly inflation report, which suggested policy rate, at 5.75%, would fall next year. The central bank said that inflation would remain on target even if it cut interest rates 0.5%, as expected by the market.

On Thursday, figures showing a surprise drop in UK retail sales added to the pressure on the pound, fuelling expectations the BoE might cut rates before the end of the year. Over the week, the pound tumbled 1.7% against the euro, lost 1.8% against the dollar and dropped 1.6% against the yen.

The yen, on the other hand, surged to an 18-month high against the greenback, as sliding equity markets saw investors unwind carry trades funded by borrowing in yen. This pushed the yen to a high of 109.13 against the greenback on Monday, its strongest level since May 2006.

Comments from the Japanese prime minister, Yasuo Fukuda, helped stem the yen’s rise.

Fukuda said the yen was appreciating too fast and warned traders and investors not to make speculative moves on the currency. He also noted that investors should be careful in order to avoid intervention from the Japanese government.

This, along with some recovery in risk appetites ensured that the yen’s gains over the week versus the greenback and the euro were small in magnitude.

The US dollar also gained against the European majors, but its gains were curtailed by some disappointing data. The US treasury’s international capital data sparked a greenback sell-off, as a mere $26.4 billion in net foreign investment entered the US during September. Given consensus forecasts of a $60 billion inflow, the result was hardly enough to quell fears of further foreign divestment of US financial assets.

This week will start with the market reacting to comments by policy makers at the weekend meeting of G-20 nations. Exchange rate issues were to be on the agenda for discussion.

Otherwise, with the year-end approaching, investors and traders’ appetite for risk could remain weak. This would help support low yielding currencies like the yen and even the dollar.

The greenback could also gain from a convergence in the market’s view with the view of some Federal Reserve officials, on the possibility of a rate cut in December.

The Fed funds’ futures market sees an 86% chance of a 0.25% rate cut. However, last week, Fed governor Randall Kroszner suggested the bank might not play along these expectations. Market participants ignored the Fed official’s comments last week, but this week, there could be some realignment.

In the local market, the risks which could trigger some near-term weakness in the rupee are growing. First among them is the increasing likelihood of profit booking by the FIIs in the local stock market. The Indian equity market outperformed some of the other regional markets last week and that increases the risk that a slump in equity markets of developed countries could force FIIs to book profits in markets like India.

Otherwise a recovery in the greenback, hardening oil prices, and slower pace of capital inflows would also put the Indian unit under some strain.

However, a shortage in rupee liquidity and the subsequent upward pressure on short-term interest rates would, to some extent, force market participants to remain short on the greenback.

This would counter the downward pressure on the rupee. Therefore the rupee-dollar pair is likely to trade in a range of 39.25-39.65, with the RBI ensuring that the rate does not fall below 39.30.

The author is senior economist, ABN Amro Bank. Views expressed herein are personal. E-mail: gaurav.
kapur@in.abnamro.com