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But Indian unit will remain under pressure as process of de-leveraging continues

Financial markets across the globe are in the midst of an intense bear phase. With the US sub-prime sector mortgage-related credit market crisis now a global financial system-wide crisis, risk-averse investors resorted to distress selling of assets last week.
It became the worst week for the stock markets since the crash of 1987, wiping out $6,200 billion in value from equities across the world. Governments and central banks stepped in to control the damage but had little success.

The UK government announced a bailout package for banks. Six major central banks led by the US Federal Reserve announced a coordinated rate cut of 0.5% each. Some Asian central banks including those of Korea and China also cut their policy rates. The Reserve Bank of Australia was the most aggressive with a 1% rate cut.

However, these efforts failed to soothe investors fearing a prolonged global recession on the back of frozen money and credit markets, troubled banking system and shrinking economic activity. The commodities market also saw a sharp slide in prices, with oil prices declining by 17.6% on the back of worries over the state of global economy.

In India, the global credit crisis has manifested in the acute weakness of the rupee and tumbling stock markets. The rupee has lost more the 20% of its value so far this year and the Sensex has lost half of its value from the peak of 21,000. Such sharp moves have contributed to extremely tight liquidity conditions in the banking system, especially as the central bank Reserve Bank of India has had to contain the rupee depreciation through dollar sales.

The problem for India has become one of severe contraction of liquidity and a sharp spiral in interest rates, on the back of capital outflows and dwindling stock markets.
Last week, the rupee depreciated by another 2.9% against the US dollar and even touched its weakest ever level in intra-day trading on Friday. The Indian unit was overwhelmed by a 16% decline in the Sensex, its biggest weekly decline in 18 years and continuing strength of the US dollar.

The greenback rallied across the board, as investors sought safety of US treasuries. The Japanese Yen was the only currency which outperformed US dollar.

The RBI and the securities market regulator Sebi acted to ease the stresses building up in the economy and the markets.

The RBI reduced the cash reserve ratio (CRR) by 1.5% to 7.50% effective October 11, releasing Rs 60,000 crore into the banking system and cancelled a government bond auction for Rs 10,000 crore.

Sebi, on its part, removed the restrictions on the issuance of participatory notes (P-notes) by the FIIs. These measures were undertaken with the objective of alleviating pressure on the rupee and addressing the acute rupee liquidity squeeze in the banking system.

The decline in the value of the rupee may continue, as in the backdrop of risk aversion and de-leveraging portfolio, investment outflows are likely to pick-up and the equity market may slide further.

The International Monetary Fund has warned that the global equity markets can fall another 20% in the worst-case scenario. These will add to the already strong downward pressure on the Indian unit due to the widening trade deficit and tepid capital inflows. There is a possibility that the overall balance of payments (BOP) could tip into a deficit in the third quarter on the back of rapid capital outflows and a large trade deficit. A BOP deficit basically implies net outflow of dollars from the economy.

The recent measures taken to improve inflow of capital are unlikely to help much in the current global market environment. The removal of restrictions on issuance of P-notes may not help prevent capital outflow or shore up portfolio inflows, at a time when emerging markets assets are being shunned by investors. Similarly, the relaxation of external commercial borrowing norms for certain sectors would also not help.

The rupee will require continued support from the RBI in the form of dollar sales, which in turn will squeeze rupee liquidity.

The reduction in the CRR will help in countering that squeeze and allow for the central bank’s dollar sales without creating undue pressure on liquidity.

The RBI has had to step up its intervention in the currency market since September. With merchandise trade deficit running at $10 billion on a monthly average basis and FIIs remaining net sellers, the RBI has had to provide at least $2.5-3 billion support to the rupee on a weekly basis. In fact, in the week ended October 3, foreign exchange reserves went down by about $8 billion, indicating the magnitude of support required from the RBI.

Some independent support to the Indian unit is likely to come from a pick-up in non-resident remittance inflows in the second half of this fiscal. Media reports also suggest that the government is considering issuing dollar-denominated bonds overseas to help improve the inflow dollars into the system.

Some pressure on the rupee can also ease once the government issues oil bonds to state oil marketing companies, as the RBI could then resume the special markets operations (SMO) with these companies. The issuance of oil bonds is likely to happen in the second half of October. Oil bonds worth Rs 25,000-30,000 crore could be issued to these companies for their under-recoveries in the first quarter of the fiscal. That will help in easing both dollar and rupee liquidity shortages in the banking system. Between end-May and July, the RBI directly sold $5.4 billion to oil companies and bought Rs 19,000 crore worth of oil bonds, under the SMO.

It also appears that the dollar shortage in the banking system has eased. Last week, the rupee-dollar forward rates turned into a discount at the start of the week, as banks’ buy-sell swap transactions pushed the premiums into the negative territory. Shortage of cash dollars prompted banks to undertake these swaps. However, by the end of the week, the forward curve was back in premium across all tenors, suggesting that situation had improved. That too reduces the pressure on the spot market value of the rupee. One has to keep a close watch on the offshore non-deliverable forwards market. This market acts as a guide for the onshore market action and is pointing towards a level of 50 for the rupee-dollar pair in the near term. Overall this week, the rupee-dollar pair may trade in the range of 48.00 - 49.00.While the bias clearly remains towards a weaker rupee, it may find some ground this week.

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