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Greenback could remain weak on Fed rate cut hopes

Robust capital inflows and the resultant problems of curbing rupee appreciation without stoking inflation and an asset price spiral, have seen another round of capital controls by the Indian authorities.

This time the capital market regulator, Securities and Exchange Board of India (Sebi), in a draft paper released on October 16, has proposed new rules to limit the use of offshore derivatives issued by FIIs to invest in the Indian stock market.

The proposed guidelines aim to phase out the use of participatory notes (PNs) by foreign investors for taking exposure to local equities, over next 18 months.

In the last few years, PNs have been a preferred instrument for offshore investors, given the ease of execution or funding.

As a result by end of August 2007, of the total assets under the custody of the FIIs, about 50% or $90 billion were funded by the issuance of PNs.

Of this amount, about $60 billion is parked in cash equities. The rest is the notional value of the PNs linked to equity derivatives, where the actual money committed through margin payments is estimated to be around $6 billion.

Therefore, as these PNs are phased out about, $66 billion can possibly flow out over the next year and a half.

The equities market tumbled on this news and the BSE Sensex ended 8.5% down from an all-time high struck last week. FII inflows have played a significant role in the strong performance of the stock market in recent years.

This is especially true of the rally since the Fed rate cut on September 18. Therefore, an attempt to curb these inflows drew a negative response from the market.

Stock market decline also took the rupee down along with it. The Indian unit depriciated by 0.9% against the US dollar, after trading in a wide range of 39.28 - 39.96 over the week.

Market participants rushed to cover their short dollar positions. The bullish sentiment towards the rupee turned to one of caution, as it was clear that the new rules are likely to cause some moderation in portfolio inflows going forward.

Moreover these new capital controls clearly signal that the government wants to prevent rapid rupee appreciation after its over 12% appreciation so far in 2007.

The impact of these capital controls, however, would be limited over the medium term. This is because the local equity markets are still largely driven by domestic rather than foreign flows, so restrictions on investments through PNs are unlikely to have a lasting impact on market performance.

At the same time, strong foreign interest in local equities, driven, suggests that a majority of foreign holders of PNs will register as FIIs with Sebi. Hence, while capital inflows could slow during the transition period, in the long run the balance of payments is likely to remain in a substantial surplus.

And that will support a stronger rupee.

Another enabling condition for continuing capital inflows into India — easy monetary policy followed by the Bank of Japan and now the US Federal Reserve — is unlikely to turn adverse anytime soon.

In fact, last week, speculation mounted that the Fed would follow up a 0.50% rate cut in September with a 0.25% reduction at the end of this month. The futures market was on Friday pricing in a 92% chance of a cut, up from about 38% on Tuesday.

Weak US economic data, including figures that showed that housing starts have plunged to their lowest level since 1993 and poor earnings figures from the banking sector, was behind heightened expectations of a rate cut. The speculators also gained confidence from the consumer prices data for September suggesting that inflationary pressures in the US economy remain relatively muted.

In this backdrop, the US dollar fell to a record low against the Euro during the week and declined against the Pound and the Yen too. The dollar index, which measures its value against a basket of six leading currencies, hit a record low of 77.406.

This week, price action in the stock market holds the key to the rupee’s movements.

Considering that the FIIs were still net buyers of Indian equities and bonds to the tune of $1 billion last week implies that we have not yet seen any actual outflow from them.

But with sentiment in the market clearly bearish, ahead of the announcement of the final P-note guidelines this week, FIIs are likely to withdraw some of their funds from local equities.

Moreover, with month-end approaching and crude oil prices having climbed close to $90 a barrel, oil companies would also be buying dollars aggressively.

The rupee is thus likely to be under pressure this week and trade in a range of 39.60 - 40.10 against the greenback.

General weakness of the US dollar and the call of the G-7 group for the Chinese currency to strengthen faster would help to counter the downward pressure.

Even exporters would take advantage of higher levels of rupee-dollar rate to offload their dollar proceeds.

The writer is senior economist, ABN Amro Bank (gaurav.kapur@in.abnamro.com)