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Merchandise trade deficit to be high on slower exports, could drag down currency

Central banks around the world, especially in the developed world, continue to take aggressive counter-action against the global financial sector crisis-driven economic slowdown. The International Monetary Fund has warned that next year developed economies face their first annual GDP contraction since the Second World War.

Last week, the Bank of England (BOE) took the lead by cutting its policy rate by 1.5% to 3% - the biggest cut since 1992 and far more than the market had expected. The Reserve Bank of Australia also exceeded forecasts with a 0.75% reduction and the Swiss National Bank made an unscheduled 0.5% cut. The European Central Bank (ECB)’s 0.5% cut, while matching market expectations, was seen as a missed opportunity to get ‘ahead of the curve’, although the ECB president hinted at further cuts to come.

In the currency market action, the pound suffered last week, on the back of the larger-than-anticipated rate cut by the BOE last Thursday.

There had been a growing consensus that an aggressive move would benefit the pound, since it showed that the BOE was being proactive in tackling the growing threat of a sharp economic slowdown. This seemed to be the case elsewhere, with the Australian dollar rising 1.2% against the US dollar on the week and climbing against the yen after the Reserve Bank of Australia surprised the market with a larger-than-expected rate cut on Tuesday.

After posting initial gains on Thursday, the pound lost ground, approaching its record low against the euro intra-day on Friday. Last week, the pound fell 2.5% against the greenback, lost 2.6% against the euro and dropped 2.7% against the yen.

The euro ended the week largely unchanged against the US dollar. The euro was initially punished after the ECB decision to cut rates by 0.5%, as a large section of the market thought that the central bank was being too cautious in dealing with the economic slowdown. The euro advanced against the greenback on Friday, as figures showed the US economy shed more jobs than expected in October. The US non-farm payrolls data showed that there were 2,40,000 job losses last month, higher than the market forecast of 2,00,000, while September’s job cuts were revised up to 2,84,000, the highest level in seven years.

Meanwhile, the ebb and flow of risk appetite and the fortunes of global stock markets continued to dictate the fortunes of the yen. Weakening equities increased the yen’s safe haven appeal and over the week, the yen rose 0.2% against the US dollar.

In the local inter-bank market, the rupee appreciated by 3.6% against the greenback over the week. The Indian unit was helped by a bounce in the stock market, on the back of a repo rate cut and other liquidity infusion measures taken by the RBI. The Sensex rose by 1.8% over the week, helped by an 843-point gain in the first two trading days of the week. Stocks gave some gains over the next two days but still finished in the positive territory. FIIs were net buyers of local assets and that too helped improve dollar supply. The market also took cues from the selling of the dollar versus the rupee in the offshore non-deliverable forward (NDF) market, especially in the near tenors. Investors favoured Asian currencies last week against the greenback. Besides, a 10% decline in oil prices also helped improve the sentiment towards local unit.

The RBI was largely on the sidelines during the week and did not sell a large amount of dollars. The central bank had intervened heavily in October to support the rupee and its foreign exchange reserves consequently went down by $31 billion during the month.
Overall the rupee-dollar pair traded in the range of 46.70-49.10.

In another move to improve the supply of the dollars, the RBI announced another unconventional measure last week. To provide dollar liquidity support to the foreign branches / subsidiaries of Indian banks, the RBI announced that it will conduct currency swaps in tenor up to three months. Following an acute shortage of dollar liquidity and dysfunctional inter-bank lending markets overseas, some Indian banks were doing buy-sell swaps transactions in the local market to fund the dollar requirements of the international branches.

These transactions put a downward pressure on the spot rupee-dollar rate (due to the buying of dollars) and pushed the forward premiums lower (due to the selling of dollars in the forward market). Under the RBI swap facility, Indian banks can now do these swap transactions with RBI and therefore, will not exert downward pressure on the rupee-dollar rate.

Also, the forward premiums which were depressed by these transactions are likely to rise. This swap window will therefore prove useful in containing the pressure on the rupee, if Indian banks with foreign branches have to take recourse of the local market for dollar liquidity.

However, external fundamentals of the Indian economy will continue to act as a drag on the rupee. As per the latest data available, merchandise trade deficit in the first half of this fiscal grew by 53% y-o-y, as exports continued to lag imports. Exports for the period stood at $95 billion, registering a 31% y-o-y growth, while imports at $154.7 billion registered 38.6% y-o-y growth. Export growth in September slowed to 10%, while import growth remained robust at 43.3%.

The exports market worsened even more in October. As per the latest ABN Amro India Manufacturing PMI, the new export orders index slipped below 50, indicating that external demand shrunk as a number of India’s key export destinations are on the verge of recession. While an easing of commodity prices, especially crude oil, will reduce the imports bill, a sharp slowdown in exports could still keep the trade deficit close to $10 billion a month.

This week, the rupee may continue to hold on to its gains, on the back of some support from the equity market and the latest move by the RBI on dollar liquidity. The market will closely watch the Index of Industrial Production (IIP) data release for September on Wednesday. In August, the y-o-y percentage growth in the IIP had slipped to a decade low of 1.3%. However, performance in September could have been better, as suggested by a relatively better growth in output of the six infrastructure sectors during that month.

That is likely to boost the equity market sentiment. Otherwise the strength of the US dollar in the overseas market will be the other major guiding force for the local market participants. The rupee-dollar pair can trade in the range of 47.40-48.20 this week.

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