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The Reserve Bank of India (RBI) delivered another dose of monetary medicine to fight the inflation fever last week. The Indian central bank once again raised both the repo rate and banks’ cash reserve ratio (CRR) by 0.50% and 0.25% respectively. That took the cumulative increase in the repo rate and the CRR to 1.25% each over the last two months.

Such aggressive monetary tightening has been in response to the headline inflation rising to a 13-year high on the back of a global commodity price spiral coupled with strong local demand conditions.

While rising interest rates help improve the prospects of a currency in general, it was not so for the rupee last week.

Concerns about continuing outflow of foreign portfolio funds overshadowed the positive impact. Higher interest rates, along with a pick-up in oil prices, impacted the equity market negatively, triggering such concerns.

On the day of the policy announcement itself, the BSE Sensex fell by 558 points and that pushed the rupee lower.

The downward pressure on the rupee was exacerbated by month-end demand for dollars by oil companies. These companies have been buying dollars from the RBI directly since May 30 under the special market operations (SMO).

Under this mechanism, the central bank was buying oil bonds from these companies and selling them dollars with a daily limit of Rs 150 crore. Over June and July, the oil companies sold oil bonds worth over Rs 1,900 crore to the RBIand bought about $4.3 billion in exchange. That exhaustedtheir stock of oil bonds and they were back in the market for buying dollars.

On Tuesday, RBI announced that the SMOs will cease, which would mean that oil companies will have to rely on the market solely for their dollar requirements. Stoppage of the SMOs could be temporary and could start once the oil companies are issued new oil bonds, but till such time, they will be in the market for dollars.

The Indian unit gained some ground towards the second half of the week, as the
equity markets recovered. Some dollar selling also emerged at rupee-dollar levels close to 42.53-42.57.

The local currency was also helped by the news that the government could extend the external commercial borrowings limit of infrastructure companies. Over the week, the rupee depreciated marginally — by about 0.2% — against the dollar.

In the international market, the greenback consolidated its gains against the European majors, the euro and pound, while the Japanese yen managed small gains against it.
The dollar strengthened,as macroeconomic data releases were less disappointing
than market participants had anticipated.

The second quarter US GDP growth printed at 1.9% annualised, undershooting market consensus estimate of 2.3% growth but better than 0.9% in the first quarter.

The non-farm payrolls, on the other hand, showed that the economy lost lesser number of jobs (51,000) compared to market estimate of job losses of 75,000 in July.
The unemployment rate, however, rose to 5.7% — the highest in 4 years, as the US manufacturing and services sectors have been cutting jobs for seven successive months now.

The ISM manufacturing index printed marginally better than consensus estimate.
In contrast, data from the eurozone showed rising inflation, plunging economic confidence and falling activity levels. Similarly, there was a succession of gloomy UK data releases.

The greenback gained 0.9% against the euro to finish the week at a one-month high against the single currency.

This week, the market focus will be on the G3 central banks. The Federal Reserve, European Central Bank (ECB) and the Bank of England (BoE) will all hold their monetary policy meetings. The post-policy statement by the Fed will be very important.

Otherwise, rates are likely to remain unchanged. Guidance by the Fed on its outlook on growth and inflation will help the markets decide which way the rates are headed in the US. Any signs of hawkishness in the form of inflation focused comments will help prop up the greenback.

On the other hand, the ECB, while leaving rates unchanged, could sound dovish in light of evidence suggesting that the growth momentum is fast losing steam and Germany, the region’s major economy, could be heading for a recession.The BoE too is likely to
keep rates unchanged despite rising inflation.

This week too, it therefore appears, the dollar could continue to consolidate on its gains. That could help in softening of crude oil prices.

Local market participants would continue to trade the rupee-dollar pair on the basis of crude oil prices, equity market conditions and strength of the greenback overseas. The possibility of lower oil prices along with gains in the equity market will help the rupee.

An announcement of oil bonds issuance to the oil companies would also prove positive for the Indian unit, given that the SMO window could be revived after that.

The government has to issue oil bonds for the fourth quarter of the last fiscal and for the first quarter of this fiscal, in order to compensate state-owned oil marketing companies for their under recoveries on the sale of fuels.

Broadly, the rupee-dollar pair can trade in the range of42.00-42.50 this week.

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