Column

Bias in favour of stronger rupee, but appreciation pace will be checked

MUMBAI: The first week of 2008 ushered in more bad news for the US economy with heightening fears of a recession either setting in or actually have set in. Crude oil prices touching $100 per barrel added to the woes. These factors led investors to shun riskier assets such as equities and opt for the safety of government bonds, as they worried about a US induced slowdown in global growth accompanied with rising inflation.

In fact, it was the worst start to a new year for the Dow Jones index in 100 years. Such risk aversion forced the unwinding of carry trades funded by low yielding Japanese yen and Swiss franc. Both currencies reaped handsome gains over the week as a result.

Worries over prospects for global growth were sparked by the ISM report on Wednesday, which said the manufacturing sector activity in the US contracted in December. The US economic outlook was darkened further by the minutes from the Federal Reserve’s December meeting, which revealed heightened fears for growth in 2008. Soaring oil prices did little to lift this gloom.

Friday’s US employment report made sure that investors finished the week in a defensive mood, as it revealed a weak growth of jobs. Net addition of 18,000 jobs in December was the weakest since August 2003 when the US economy shed 42,000 jobs. Prospects of slowing global growth combined with rising inflationary pressures pushed investors away from carry trades.

As a result, the yen outperformed other major currencies. Over the last week, yen rose 3.5% against the greenback, it climbed 3.4% against the euro and gained 4.6% against the pound. Yen also rose 3.9% and 4.6% against the higher-yielding Australian and New Zealand dollars respectively.

Swiss franc, the second favourite funding currency among carry trade investors, also advanced. The Swiss franc, which was given an additional boost as figures showed Swiss inflation hit a 12-year high in December, rose 2.8% against the US dollar, was up 2.6% against the euro and climbed 3.6% against the pound.

Meanwhile, the US dollar lost ground to the euro but appreciated against the pound.

The greenback fell 0.2% against the euro over the week, while it gained by over 1% against the pound. The greenback tumbled against the yen, as poor data led market participants to price in a higher likelihood of the Fed cutting rates by 0.5% (instead of a 0.25% cut) at its January monetary policy meeting. The Fed fund futures contract on Thursday was indicating a 24% chance of a 0.5% cut on January 30. After Friday’s employment report this had risen to 46%.

The pound, which was worst performer among major currencies, dropped as the Bank of England’s (BOE) credit conditions report showed the turmoil in the credit markets had spilled over into the rest of the economy in the last quarter of 2007 and was likely to depress consumer spending in the first quarter of 2008. Market participants perceived that this news, combined with recent evidence showing that the UK housing market had stalled, increased the pressure on the BOE to cut interest rates at its meeting this week.

In the local inter-bank market, rupee appreciated marginally against the dollar last week. Factors such as the stock market soaring to a new high, net buying of local assets by the FIIs and the weakness of US dollar overseas, kept up the pressure on the rupee to appreciate. This pressure was negated somewhat by the rising crude oil prices and RBI’s intervention in the market. Rupee was also buoyed by RBI governor’s statement that exchange rate flexibility was desirable.

Overall price action in the rupee-dollar pair was range-bound and the pair traded in a narrow band of 39.29-39.475. In the rupee-dollar forwards market, premia eased across tenors on the back of a sharp decline in short-term interest rates following an improvement in the rupee liquidity situation in the banking system.

This week, while the continuing weakness of the greenback favours a stronger rupee, the mood of risk aversion among global investors, record high oil prices and RBI intervention would check the pace of appreciation for the rupee.

If the gloom among investors persists, global equity markets could suffer more losses, which would be negative for the local stock market too. As for the RBI, its intervention over the last two months has been relatively smaller on the back of a slowdown in the inflow of capital into India. With these inflows likely to pick up again on the back of large initial public offerings during this month, the RBI is likely to intervene heavily to keep a lid on the pace of rupee appreciation.

The central bank is also less constrained in its capacity to sterilise the injection of rupee liquidity from its spot market intervention given that its issuance of bonds under the Market Stabilisation Scheme has been fairly limited since early November. In terms of trading range, the rupee-dollar pair could move in the band of 39.20-39.50 this week.

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