Dollar rebound could keep rupee under pressure

Fears that China is poised to raise interest rates and worries over the eurozone’s fiscal crisis battered risk appetite in the financial markets last week.

In the eurozone, Ireland was in focus due to fears of sovereign debt restructuring, which drove yield spreads on Irish and Portuguese bonds to record wide levels over their German counterparts. The escalating sovereign debt turmoil in Ireland and Portugal heightened concerns that contagion could drag other eurozone countries into trouble as well, delaying the European Central Bank’s attempts to normalise interest rates in the region.

In Asia, increasing speculation that China was set to ramp up its monetary tightening efforts following stronger-than-expected inflation data prompted fears of weakening demand.

Events in China and eurozone prompted a return of risk aversion and investors booked some profits and parked their cash in the safe haven of the US dollar. The greenback had its first weekly gain since the US Federal Reserve chairman Ben Bernanke paved the way for further quantitative easing in late August.

The greenback also rallied as the gathering of G20 leaders in Seoul made little progress on defusing international currency tensions, merely agreeing that the findings of their previous meeting should be enacted.  Having hit its lowest level of the year last week, the greenback rallied across the board. It climbed 1.5% against the yen. Emerging market and high-yielding currencies lost out as investors shied away from risk.

The euro was the worst-performing of the major currencies after a re-emergence of concerns over the state of eurozone sovereign debt. While rumours of an imminent bailout of Ireland helped steady the euro on Friday, it was down 2.4% over the week against the US dollar. The euro was down 0.9% over the week against the yen.

The pound showed mixed performance as market participants were left uncertain about the Bank of England’s next move after its latest quarterly inflation report reinforced the divisions between the members of the monetary policy committee. It appeared that the “wait and see” faction would prevail. Sterling was down 0.3% against the US dollar but was 2.2% higher versus the euro and 0.9% higher to the yen.

The Chinese inflation data prompted the People’s Bank of China to raise the daily reference rate of the renminbi against the US dollar. Some of China’s biggest banks were also ordered to increase their reserve requirements, paving the way for further renminbi strength. The Chinese currency rose 0.3% over the week.
In the local market, rupee hit a six-week low against the US dollar last week. The Indian unit fell sharply on Friday after being steady for most of the week as stock market by close to 500 points and the G20 leaders talked about imposing controls on speculative capital flows to emerging markets. Earlier in the week, rupee was supported by FII inflows ahead of the Power Grid FPO. The Indian unit was able to withstand the pressure from a rising greenback overseas on the back of strong portfolio inflows. However, on Friday the rupee slipped as US dollar continued to gain and stock market decline gathered pace.

Weaker-than-expected industrial production numbers for the month of September also affected the rupee negatively, contributing to the equity market decline. Over the week, the rupee-dollar pair traded in the range of 44.2375-44.845.

Going forward, the revival of the European financial crisis is one of the key themes for the financial markets. Back in May, the European Union had to act in conjunction with the IMF to bailout Greece and they created a standing European Financial Stability Facility (EFSF) that represented a 750 billion euro safety net. The intent of this fund was to eliminate market fears that any EU member was at risk of default. Media reports last week suggested that Ireland was drafting a call for aid from the EFSF. Any confirmation of this is going to further hit the risk sentiment and help the US dollar.

The greenback’s status as a safe haven is well known. However, the US dollar’s pure fundamental appeal as a global refuge has certainly diminished over time. With the Fed’s aggressive stimulus efforts and the constant effort made by global authorities to diversify away from the dollar denominated assets, the greenback’s investment appeal has diminished. That said, should the alarm of crisis be sounded, these issues will be easily ignored. If equities, commodities and debt falter globally, the US dollar will look appealing.  Moreover, with G-20 endorsing curbs to speculative capital inflows for emerging markets, any such controls will ultimaltely help the US dollar.

In the local market, price action would depend on the strength of the greenback overseas and local stock market movements. It appears that the equities market is losing some steam as was witnessed in the last week’s stock market decline. If that continues this week, then rupee will remain under pressure. Market conditions also seem ripe for an extension of the US dollar rally overseas and that too would affect the rupee. However, acute liquidity tightness in the banking system is helping the rupee too.

Overall this week, rupee could trade with a weakening bias and the rupee-dollar pair can trade in the range of 44.50 -45.00.

(The author is senior economist, Royal Bank of Scotland N.V. Views expressed herein are personal. e-mail: gaurav.kapur@rbs.com)