Column

Last week, the financial markets saw their most turbulent week in the last two decades. The credit market crisis that has gripped markets across the world since August last year claimed more victims in the US financial sector last week. Investment banks Lehman Brothers and Merrill Lynch and insurance company AIG joined ranks with Bear Sterns, Freddie Mac and Fannie Mae among the victims of the sub-prime mortgage assets-related crisis. That triggered intense risk aversion and riskier asset classes, especially equities, sank.

All major central banks across the globe swung into action to contain the damage. The US Federal Reserve, the US Treasury and financial markets regulator SEC were at the forefront of the damage control exercise. By the end of the week, markets stabilised and equities rallied on support from governments and central banks across the globe.

Currency markets too saw sharp volatility. With the bankruptcy of Lehman Brothers, followed by the state-sponsored bail-out of US’ largest insurer AIG, the natural reaction might have been a sharp sell-off in the US dollar. However, economic fundamentals took a backseat with the crisis in the US financial system permeating every market across the globe. In the midst of the turmoil, the greenback found support, as rising risk aversion prompted US investors to unwind overseas investments and repatriate funds. The dollar seesawed over the week though.

The greenback staged a rally on Friday on news that the US government was planning to launch a vehicle to take on the toxic assets that have wreaked havoc across financial markets. Hopes that a deal could be in sight to create a vehicle modelled on the lines of the Resolution Trust Corporation - used to clean up the system after the Savings and Loan crisis of the 1980s - fuelled a surge in stocks and boosted the greenback.

Over the week, however, the US dollar eased 1.7% against the euro and lost 2.1% against the pound.

In the local market, the rupee was also very volatile. Over the week, the rupee-dollar pair traded in a very wide range of 45.53-46.98 and the rupee depreciated by 0.2% against the US dollar.

The Indian unit came under tremendous pressure in the first two days of the week, as the greenback surged overseas and local stock market crashed. The arbitrage between the offshore NDF market and the onshore forwards market continued to act against the rupee too. Foreign institutional investors sold $1.1 billion worth of Indian stocks and bonds over the week, adding to the pressure on the rupee.

The rupee-dollar pair almost touched the 47.00 level on Tuesday. Dollar liquidity shortage in the banking system also prompted banks to enter swap transactions involving buying dollars in the spot market and selling them forward. That kept the pressure on the spot rupee and drove down the forward premia across all tenors.
The RBI support to the rupee through its massive dollar sales helped arrest pressure on the Indian unit.

The Indian central bank also allowed banks to pay higher interest rates on deposits of non-resident Indians in a bid to attract more dollar inflows through this route. Measures to alleviate the rupee liquidity crunch in the banking system, which include a temporary cut in the banks’ statutory liquidity ratio (SLR), were also announced. The RBI thus ensured orderly conditions in the local markets and that helped improve market sentiment.

The rupee rapidly recovered most of it losses on Friday on the back of 726 points rally in the BSE Sensex. Stock markets across the world rallied on that day after the US Treasury promised a massive clean-up of toxic mortgage debt stuck on the books of the biggest banks, pledged $50 billion to help the beleaguered money market funds, and moved to curb short-selling.

This week too the flow of news from the US will be very critical. Over the weekend, the US government has proposed a $700-billion plan to buy out sub-prime related assets from troubled US financial institutions. This will help soothe the frayed nerves of investors and restore risk appetite as markets open on Monday.

Volatility in the financial markets will remain high as the long-term outlook is still very uncertain. The US dollar could therefore take some beating, especially since it has a significant yield disadvantage. And, the turmoil in the financial sector has bolstered the case for a rate cut by the Fed. Last week, the Fed left the overnight funds rate unchanged at 2%.

The impact of any weakness in the greenback might only be beneficial for the rupee on the margin. Any significant weakness in the US dollar will drive up commodity prices, particularly that of oil and gold. Last week, crude oil prices rose by 2.8%. That negates much of the benefit of a weaker dollar. Even otherwise, global investors will remain cautious about emerging market asset classes and therefore, Indian equities are prone to a continuation of sell-off by the FIIs.

However, with a likely improvement in risk appetite, the equity market conditions could remain broadly supportive for the rupee.

Market participants will also eagerly await any further clarifications from the ministry of finance on its proposal to review the external commercial borrowings (ECB) guidelines at the end of this month. The ECBs had emerged as one of the main sources of capital inflow into India and last year, following a glut of inflows, the government had put stringent restrictions on these borrowings.

However, now with rupee under pressure and capital inflows having dried up, the government and the RBI are looking to relax the restrictions. Moreover, a fairly large size of these borrowings is due for repayment later this year. That could put rupee under pressure too. Therefore, any relaxation of restrictive guidelines would be helpful for the rupee.

Overall, the rupee-dollar pair will continue to trade in relatively wider range given the volatile market conditions. The pair can trade in the range of 45.50-46.50 with a weakening bias for the rupee over this week.

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