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Calm returned in the financial markets last week, as major central banks’ move to inject liquidity helped improve sentiment.

Several large banks in the US tapped the Federal Reserve’s discount window to borrow funds. The European central bank also injected liquidity into the money market. Such actions reassured market participants that funds will be available for good quality borrowers.

The appetite for riskier assets recovered as a result and the equity markets rallied across the globe. Global equity markets had a very strong week, with the MSCI All-World index rising more than 3%.

A powerful rally for Asian stocks led the way as the MSCI Asia-Pacific (ex-Japan) index rebounded 13% from a five-month low struck in the week before last. Riskier asset markets were not devoid of volatility though, indicating that the underlying picture remained one of uncertainty.

With the return of risk appetite, currency markets witnessed a familiar trading pattern, one of buying the high yielding currencies against the currencies with low yield support. Further ammunition for these carry trade was provided by the Bank of Japan’s decision to leave interest rates at 0.5%.

Over the week, the Japanese yen underperformed the other three majors and the other high-yielding currencies like the Australian, New Zealand and Canadian dollars.

The US dollar rose 1.8% over the week versus the yen, while the euro gained 3.3%. Against the highest yielding currencies, the yen fell more sharply. The New Zealand dollar rose 4.5%, the Australian dollar climbed 4.6% and sterling added 3.5%.

The US dollar also finished lower against the European majors. The greenback fell after move by the Fed to cut the discount rate from 6.25% to 5.75%.

This has prompted heightened expectations that the US central bank would cut its benchmark Fed funds rate, which stands at 5.25%. The Fed funds futures are pricing in at least two cuts before the end of this year, with a near certain cut in September.

In the local currency market, the rupee also recovered some of the ground it lost to the greenback in the week before last. The global equity market rally had a positive spillover on the local stocks. However, political tensions at the Centre kept investors cautious.

In terms of flows, FIIs remained net sellers of Indian stocks and bonds. Their net sales last week amounted $879 million. Exporters, however, offloaded their dollars, wanting to make the most of the decline in the value of the rupee. The rupee-dollar pair traded in the range of 40.77-41.251 last week and appreciated by about 0.5% over the week.

This week too the equity market action would drive the price action in the rupee-dollar pair. While the sentiment towards local equities will remain positive helped by the improvement in the risk appetite among global investors, FIIs are likely to remain on the sidelines.

Hence, rupee will receive a sentiment boost, but the actual dollar inflows from FIIs could still remain elusive. This lack of portfolio inflows could prove negative for the rupee, in case the exporters also hold back on their dollar sales.

The month-end demand for dollars from importers, particularly oil traders, is likely to put pressure on the rupee this week. A prolonged political stalemate at the Centre will also prove negative for the rupee.

The Indian unit would, however, be supported by the general weakness in the greenback, which could suffer more looses as risk appetites keep improving.

Any softness in the international crude oil prices, like last week, would also prove beneficial for the rupee. Overall, the rupee may continue to trade with a bias to weaken against the US dollar. The trading range for the rupee-dollar pair is likely to be 40.75-41.25.

Market participants would also reassess the extent of the negative impact of the restrictive external commercial borrowing (ECBs) norms on the rupee. Data released last week by the RBI showed that ECBs amounted to $5.7 billion in April and May 2007.

The details of the data, however, showed that a large part of these proceeds would be utilised outside the country on things like import of capital goods, while the rupee expenditure out of these proceeds was relatively small.

Such a spending pattern could restrict the negative impact of the curbs imposed on ECBs on the rupee, even as dollar inflows from this source dry up over the rest of the year.

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