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Falling stock market, weak external fundamentals ail Indian unit

Risk aversion was the all-pervasive market sentiment last week. The fragile optimism that followed October’s collapse in equity markets evaporated as growing concerns about the severity of the global economic slowdown prompted a fresh bout of turmoil.

Equity markets tumbled amid renewed fears for US carmakers and financial companies along with concerns over the effectiveness of the US government’s bailout plan. That prompted another round of de-leveraging. As a result, crude oil prices eased below $50 a barrel and yield on safest asset class, US government bonds, fell across fell to historic lows.

In the currency markets, the combination of risk aversion and de-leveraging boosted the yen, as investors liquidated positions in riskier, higher-yielding assets that had been funded by borrowing in the low-yielding yen. On Thursday, the yen rose to a two-week high against the euro and the dollar, as the US stock market hit an 11-year low. But it gave back some gains after Japan’s finance minister reaffirmed the authorities’ threat to intervene directly in the market to slow the pace of yen appreciation. Over the week, the yen rose 1.1% against the greenback, was up 1.5% against the euro and gained 0.2% against the pound.

The US dollar, which has benefited from safe haven flows during the recent turmoil, also received support, rising 0.4% against the euro over the week. Meanwhile, the pound recovered from a record low against the euro and a 6-year bottom against the greenback.

The pound, which has been undermined by aggressive interest rate cuts from the Bank of England and a flurry of gloomy economic data points, rallied on hopes that the UK government would make tax changes that could make repatriating overseas earnings a more attractive option for UK companies. Over the week, the pound rose 0.9% against the US dollar and climbed 1.3% against the euro.

The Swiss franc fell to its weakest level against the greenback in 15 months after the Swiss National Bank (SNB) surprised the market by cutting interest rates on Thursday and warned of a slowdown in economic activity. The SNB cut its three-month target range by 1% to 0.5-1.5%. It was the third time in two months that the SNB had eased monetary policy outside a scheduled meeting. Over the week, the Swiss franc fell 2.2% against the US dollar.

Emerging market currencies came under renewed pressure, as increasing risk aversion prompted foreign investors to repatriate funds. The South Korean won lost 6.7% over the week against the dollar, the Brazilian real fell 10.4% and the Turkish lira slid 4.5%.

In the local market, the rupee also depreciated by 2.2% against the US dollar. That took the rupee-dollar pair past the 50 mark once again. Sliding stock market, the greenback’s strength in the overseas market, along with dollar demand from importers, pulled the rupee down during the week. An arbitrage opportunity in the non-deliverable forwards market also prompted some amount of dollar buying. The RBI stepped in and curbed the pace of rupee depreciation.

Last week, the FIIs net purchases were $58.7 million, taking their total net purchases in November to $407.4 million. FIIs, who have been net sellers so far this fiscal, have been net buyers of local stocks and bonds so far this month. Overall the rupee-dollar pair traded in a wide range of 48.78-50.57 over the previous week.

The positives for the rupee at this juncture are far and few. The currency is being pulled down by a large trade deficit and tepid capital inflows. On the current account, despite a sharp slide in oil prices which fell below $50 a barrel last week, the deficit is likely to be in the vicinity of 2-2.5% of GDP this year compared with 1.5% of GDP in the last fiscal. That is on account of a sharp slowdown in the exports in the second half of the current fiscal. Merchandise exports have been severely hit in a number of industries and ITeS exports are also likely to be negatively impacted, given that the US financial sector is major market for the sector.

The capital account, on the other hand, will still be in surplus this year, despite outflows on the portfolio front. But the magnitude of the capital account surplus might not be large enough to fund current account deficit. Therefore, the overall balance of payments (BoP) is likely to be in deficit this fiscal, for the first time since 1995-96. This compares to a massive surplus of $92.2 billion in the previous fiscal. This fundamental worsening of the India’s external balance position has been one of the key reasons behind the rupee’s 25% depreciation against the greenback so far this year.

The RBI has actively supported the rupee and its dollar sales were especially large in October. As a result, RBI’s foreign exchange reserves went down by $57 billion between April and October. However, the actual dollar sales by the RBI, which is the measure of the aggregate BOP position, is about $25 billion, after taking into account valuation losses on the reserves and the unwinding of its long dollar position in the forwards market.

The other key driver of the rupee-dollar pair, the strength of the dollar itself against other currencies, especially emerging market ones, is also likely to persist in this environment of heightened risk aversion among investors. This week the greenback’s strength could however, be tempered a little by the release of the revised third quarter GDP data, considering that the revised data could show a sharper decline in real GDP than earlier estimated. Otherwise the US dollar is likely to dominate other major currencies, except the yen.

This week the local stock market will remain vulnerable to the developments in the US related to the government decision on bailing out big carmakers and the troubles in the financial sector, with Citigroup now in the need of capital infusion. That is more likely to feed into risk aversion and therefore the local stock market could lose more ground.

The rupee would feel the pressure from a falling stock market and the overall weak external fundamentals.

The RBI will continue to support the rupee. Even otherwise the central bank could soon be announcing another round of aggressive rate cuts along with other measures to ensure adequate rupee liquidity and credit growth. The government is also considering a package to help the ailing exports sector. Any efforts on the part of the RBI or the government to alleviate the stresses in the economy are likely to help the rupee. Overall, the rupee-dollar pair is likely to trade in the range of 49.50-51.00 this week.

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