Column

Rising inflation, high commodity prices, comfortable liquidity could prompt move

The rupee is wilting under pressure and has depreciated 2.8% against the US dollar so far in 2008. Last week, the rupee lost 1.3% in value against the dollar, despite another week of greenback falling to new lows in the overseas market.

With negatives outweighing the positives, the Indian unit can lose more ground in the near-term.

The rupee’s decline over recent weeks has come on the back of a marked slowdown in capital inflows, particularly from foreign institutional investors (FIIs).

The risk aversion mood among global investors has led them to shun equities, and their exposure to the Indian market has been reduced. The FIIs pulled
out $482 million from the Indian market last week, while the BSE Sensex slumped further. The situation on the portfolio inflows front is unlikely to improve significantly over the next few months, as the credit market crisis is still unfolding.

After banks, it’s now bond insurers who have been in the news for their exposure to the subprime sector and the possibility of losses and ratings downgrade thereof. Also, with the chances of a US recession leading to a slowdown in global growth, investors are reluctant to allocate funds even to emerging markets equities.

While capital inflows are placid, the merchandise trade deficit is growing sharply.
As per the latest data, between April 2007 to January 2008, trade deficit was at $67.4 billion, 47.5% larger than the deficit in the same year-ago period. This widening is occurring as growth in imports outstrips the growth in exports.

And, with commodity prices - particularly oil and gold - at record highs and rising, the trade deficit will only increase. These trade pressures are now exerting some depreciation pressure on the rupee. The situation on the trade front will only worsen until about June, as imports typically see stronger growth during the April - June quarter of the fiscal year.

The lack of capital inflows and the RBI’s aggressive buying of dollars in the currency market have created a dollar-shortage in the inter-bank market.

That has forced banks to enter buy-sell swaps between the cash/ spot and forwards market. Such actions have led to the rupee weakening in the spotmarket and forward premiums dipping into negative territory.

The central bank has tried to alleviate the situation by entering into sell-buy swaps, after which the inter-bank dollar position seems to have improved last week.

The RBI, otherwise, has largely refrained from supporting the rupee by selling dollars. However, as the rupee weakens further against the greenback and even more against the other major currencies, inflationary pressures through imported commodities will be felt more severely.

Headline inflation has already crossed the RBI’s comfort level of 5% and rising commodity prices and a weaker rupee will only push it higher.

The RBI would be cognizant of this fact and would try to prevent any significant depreciation of the rupee. Moreover, with an improvement in the rupee liquidity in the banking system, the RBI has the room to sell dollars.

The rupee, therefore, could receive some support this week from the central bank. Rising inflation would also keep the RBI away from easing interest rates and that will widen the interest differential in favour of the rupee, especially as the US Federal Reserve cuts rates further over the coming months.

The dollar’s free fall in the overseas market is also not helping the rupee. The greenback had another grim week, as dismal employment data showing job cuts for the second successive month. The largest monthly decline in payrolls in five years assured market participants that the Fed will cut rates by 0.75% in March.

On the other hand, both the European Central Bank and Bank of England left their policy rates unchanged, which helped the euro and the British pound, respectively. The ECB president also hinted that inflation was a bigger concern.

Also, another round of risk aversion triggered a reversal of carry trades, which saw the Japanese yen gain sharply. Last week, the greenback lost over 1% in value to all the three currencies.

However, the persistent decline in the value of the US dollar and rising inflation triggered a surge in commodity prices. Energy and precious metals led the charge. Oil prices rose by 3.3% over the week, prompting local oil companies to buy dollars.

Overall, the weakness in the greenback is working against the rupee at the moment, given India’s large commodities import bill.

This week in the US, retail sales, consumer price inflation and trade deficit data are due for release. Retail sales data is likely to be dollar bearish, while new from the other two data will be helpful for the greenback. But with the Fed more concerned about growth than inflation at the moment, the greenback is likely to remain under pressure.
In the local market, the RBI’s actions are critical for the rupee.

Any support to it at the current levels could provide some resistance to further decline. Otherwise, the rupee will remain under pressure on a number of fronts. Overall, the rupee-dollar pair could trade in the range of 40.20 - 40.80 this week, compared to a trading range of 39.81 - 40.64 last week.

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