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RBI moves, along with the fiscal boost, will improve sentiment

Financial markets were buffeted by grim macroeconomic data from around the world last week. The US economy slipped into recession in December 2007, confirmed the National Bureau of Economics Research. The US non-farm payrolls data showed the biggest monthly job losses since 1974 in November. The US ISM Manufacturing Index indicated that activity shrank to its weakest since 1982. Manufacturing activity, as measured by the purchasing managers index (PMI), also plummeted to record lows in the Eurozone, the UK, Australia, Russia and China during last month. Even in India, the ABN Amro Manufacturing PMI index printed at 45.8, below the critical level of 50, signalling contraction in the sector for the first time in over three and a half years.

Against the backdrop of collapsing growth and the threat of deflation, central banks in the UK, Europe, Australia, New Zealand and Sweden aggressively eased policy. The Reserve Bank of India (RBI) also announced a 1% cut in its policy rates on Saturday, noting the rapid deterioration in growth momentum in the economy.

In the currency market, the pound bore the brunt of a relentlessly gloomy week of economic data. The pound lost 4.1% against the US dollar as it continued a slide that has seen it fall 27% since mid-July. Against the euro, it touched a record low, finishing the week lower by 4.6%.

On Thursday, the Bank of England cut interest rates by 1% to 2%, the lowest level since 1951, in an attempt to boost the UK economy.The move was followed up by a 0.75% rate cut by the European Central Bank (ECB) to 2.5% — the biggest easing in its near 10-year history. The ECB’s aggressive cut appeared to be justified by figures released on Friday, showing that German manufacturing orders in October tumbled by a whopping 6.1% month-on-month.

The euro fell 0.3% against the US dollar over the week and dropped 2.4% against the yen. The currency’s decline against the greenback came despite US employment data on Friday showing the third-largest number of monthly job losses since that data series began. The low-yielding Japanese currency, seen by investors as a relatively safe asset, reasserted itself, as it appreciated by 2.7% against the greenback over the week.

Elsewhere, the Central Bank of Russia allowed the rouble to fall against its US dollar/euro basket on Friday for the fourth time in as many weeks. In China, the yuan posted a record one-day drop against the greenback on Monday — retreating 0.9% — as speculation grew that Chinese authorities would allow the pegged currency to weaken to boost exports.

In the local inter-bank currency market, the rupee appreciated 1% against the US dollar helped by some improvement in the supply of dollars. Exporters and some other corporates’ sold dollars on the back of expectations that rate cuts and a fiscal stimulus package by the government will help the rupee recover.FIIs also remained net buyers of Indian assets and bought $274.7 million worth of stocks and bonds last week. Falling oil prices and RBI’s direct sale of dollars to oil companies also provided some support to the rupee. Crude oil prices fell by 26% over the week to touch a level of $42 a barrel. The RBI also supported the rupee through direct intervention in the market. The rupee-dollar pair traded in the range of 49.51-50.58 over the week.

Demand for dollars from importers, however, kept the rupee under pressure. Despite a sharp slide in crude oil prices, India’s trade deficit has widened and remains high. As per the latest data, merchandise trade deficit stood at $73 billion during the April-October 2008 period, 60% higher than the same period last year. Shrinking external demand in the backdrop of recession in most of the developed world is now severely affecting exports from India. In October, exports contracted by 12% over their levels in October 2007. This was the first time in five years that exports growth slipped into a negative territory. While imports growth also slowed down during the month, the trade deficit was still at $10.5 billion. In November, it is quite likely that exports shrink further.
The exports order index of the ABN Amro PMI survey printed below 50, at 46.7, signalling further contraction in external demand for Indian goods. Thus, the pressure on the rupee from a burgeoning trade deficit may persist for some more time.

This week, the rupee is likely to get a boost from the economic stimulus package. Rate cuts by the RBI will lower the cost of funds in the economy and will help boost credit demand. The fuel price cut announced on Friday will hasten the momentum of the decline in the WPI inflation and support consumption spending.

Government support through a Central value-added tax (Cenvat) rate cut, financial support to infrastructure development and specific fiscal support to ailing sectors, especially the exports sector, would also help boost overall activity in the economy. These steps will provide positive momentum for the stock market too. Counter cyclical measures to support growth will also help improve investor sentiment towards India.

This week, therefore, the rupee-dollar pair may trade in the range of 48.50-49.50. The downside risk to the Indian unit emanates mainly from a strong US dollar.

In the global currency markets, the US economic calendar for the week ahead will continue to test the risk aversion-driven strength of the US dollar in the face of troubles in the economy. Market participants have already priced in a recession. But the severity and length of a contraction may be a question mark.

A few growth-related indicators will shed some light on that. Pending home sales will gauge the ongoing housing market recession while the trade balance will reveal how effective a cheaper greenback is in boosting exports. The consumer will be the more important focus with retail sales for November accounting for the build-up in spending trends into the holiday season while consumer sentiment will guide speculation for it going forward. Also thematic is inflation. Though factory and import-level price gauges are usually second-tier readings, an expected plunge in annual readings would spell deflation, which the US Federal Reserve will certainly want to avoid.

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