Column

The rupee remains stuck in a tight range. It’s caught between a voracious appetite for local equities among foreign institutional investors (FIIs) and the firm resolve of the Reserve Bank of India (RBI) to keep a lid on its appreciation.

Last week, these opposing forces ensured that the rupee-dollar pair move in a very narrow range of 40.30-40.455.

While the FIIs bought another bunch of local equities and bonds worth $1.7 billion, taking their total July purchases to $5.4 billion, the RBI continued to buy dollars from the inter-bank market.

In the face of such large capital inflows, the RBI has been intervening in bigger sizes in July. As per the latest data, the RBI added another $4.1 billion to its forex reserve holdings during the week of July 13.

This week, demand for dollars by oil companies towards the month-end would help in mopping up greenbacks from the inter-bank market.

Moreover, with international crude oil prices ruling above $75 per barrel and still headed upwards, oil companies will require more dollars to meet their import bill.

Even other commodity prices have risen recently and this will add to the Indian currency’s pressure in the near future.

The surfeit of liquidity in the banking system, by pulling down short-term interest rates, is also helping to keep the
rupee under pressure.

Overnight call money rate remains below 0.5%, and last week, even other shorter tenor rates, particularly up to 3 months, eased sharply.

Thus, the cost of holding short-dollar positions, in terms of forgone interest, has increased, given that the dollar Libor in these tenors is much higher.

This would dissuade market participants like banks to keep short-dollar positions and force them to cover such positions from time to time.

In the rupee-dollar forwards market, falling interest rates and the resultant negative interest rate differential between local and US rates, has pushed the premia for buying or selling dollars into a negative territory for tenors up to two months.

This could actually induce some importer buying of forward dollars in these tenors, as greenbacks are available at a discount to the spot rate.

These downward pressures, however, can only weaken the rupee versus the US dollar, if capital inflows, especially from the FIIs, thin down.

There is a possibility of that happening this week. Another wave of risk aversion among investors hit risky assets on Friday, following concerns that the subprime mortgage market problems in the US could spill over to Europe.

In fact, US Federal Reserve chairman Ben Bernanke did warn about such a contagion in his semi-annual testimony to the Congressional committees last week.

If these concerns gain more ground this week, carry trades would be unwound and investors would reduce their risky asset allocations. Indian equities would also be caught in this wave, if it prolongs.

Otherwise, the outlook towards these inflows remains very positive and their quantum is likely to exceed the current account deficit by many times this fiscal year, too.

Therefore, in order to prevent rapid rupee appreciation under such circumstances, the Prime Minister’s Economic Advisory Council has suggested some curbs on debt, creating capital inflows like external commercial borrowings (ECB).

More specifically, they suggest limiting conversion of ECB proceeds into rupees, so that these borrowings are largely used to meet expenditure in foreign currency.

The council’s suggestions for tackling these excess capital inflows also include RBI intervention and liberalisation of capital outflows.

Overall, this week, the rupee could slip a little and the rupee-dollar rate could move in the 40.35-40.70 range.

In the international market, the US dollar remained an underperformer among the major currencies while the pound emerged again at the top last week.

The prospects of further interest rate hikes in the UK increased after stronger-than-expected inflation and growth data. The sterling hit a 26-year high against the greenback on Tuesday after consumer price inflation rose faster than expected.

Friday’s second-quarter gross domestic product data showed a growth of 0.8%, beating expectations of a 0.7% rise and bringing annual growth to 3%.

This robust data challenged the growing belief in the market that the Bank of England is likely to adopt a wait-and-watch stance for some time after it raised rates this month to 5.75%.

The US dollar continued to be undermined by the impact of the subprime mortgage crisis. US consumer prices failed to provide any surprises, and Bernanke’s testimony was unable to lend the ailing greenback any support.

He said core inflation in the US had moderated in the past few months, while the pace of home sales was likely to remain sluggish for some time.

The yen had some respite as the problems surrounding the greenback and a sell-off on global equity markets on Friday, prompted the unwinding of carry-trade positions.

In the middle of the week, however, the hunger for yield among investors had pulled the yen down. Over the week, the Japanese currency outperformed the Euro and the greenback.

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