Column

This week promises to be an eventful one in the currency market. Investors across the globe are undergoing another round of risk aversion, on concerns that the sub-prime mortgages-relatedtroubles in the US economy could spill over to other economies and could even affect the conventional loan market.

This led to a sell-off across riskier asset classes last week, especially towards the end of the week. While, initially, only the credit market reacted with tightening of credit spreads, on Friday, equity markets across the globe also tumbled.

While risky assets were being offloaded, money found its way back to safer havens like the US government bonds and that helped the greenback rally. Investors also unwound carry trades in a big way.

The Indian equity market was caught in this frenzy and the BSE Sensex crashed by over 500 points on Friday.

The Indian rupee also lost value against the dollar, as foreign institutional investors (FIIs) sold their local equity holdings and banks rushed to cover their short-dollar positions.

If this wave of risk aversion persists, local stocks and the rupee will both be under pressure again.

It is quite likely that investors would remain cautious early in the week. Any optimism over stronger-than-expected second quarter US GDP growth of 3.4% would be tempered by the fact that consumer spending growth slowed down and the housing sector contributed negatively to the overall growth.

A number of critical data releases, including the ISM’s activity surveys of manufacturing and services and the non-farm payrolls, are due this week in the US. These numbers, in the recent months, have been robust, particularly the employment data.

This time, too, these indicators are expected to show strong readings. Therefore, by the end of the week, market participants are likely to regain some confidence on the pace of growth in the US. That would stoke their risk appetites again.

Given the impact of these global developments on local asset prices, local market participants would continue to be wary of them.

A rebound in the equity markets would certainly help the rupee gain some of the lost ground and vice-versa.

While global asset market action will be crucial, a significant domestic event is due this week. The RBI will hold its quarterly monetary policy meeting on July 31.

It’s likely to keep its policy rates unchanged while maintaining a hawkish stance. More importantly, the RBI could raise or remove the limit of Rs 3,000 crore on its daily absorption of surplus funds from the banking system through reverse-repo transactions.

Due to this limit and the RBI’s aggressive intervention in the currency market, surplus liquidity has built up in the banking system.

That has led to a sharp decline in interest rates in July, particularly the overnight call money rate and other short-tenor rates. This, in turn, has kept the rupee under some pressure.

Therefore, if the RBI raises the limit of liquidity it absorbs from the banking system, short-term rates would rise and that will be positive for the rupee.

Moreover, considering the problems the RBI is facing with managing excess capital inflows, it could also liberalise capital outflows further and implement some measures to check capital inflows like compulsory hedging of external commercial borrowings.

Any such measures would have an adverse impact on the rupee in the medium term.

The usual month-end demand for dollars by oil companies and other importers would also add to the downward pressures on the Indian unit. The scales, therefore, are largely tipped against the rupee. This week, too, it could weaken against the US dollar.

Last week, after touching its strongest level in 9 years against the dollar, the Indian unit slipped sharply in the second half of the week. As a result, the rupee-dollar rate moved in wider range of 40.18 - 40.57. This week, the pair can trade in the range of 40.45 - 40.75.

In the international price action last week, turmoil in global assets markets saw a sell-off in high-yielding and emerging market currencies. The yen, which has hit multi-year lows against a raft of currencies in recent months, was the main beneficiary of the rout.

The greenback was the main focus of selling pressure early in the week. It fell to a record low against European majors on Tuesday.

As it became clear that the problems in the US were spilling over, contributing to sharp falls in global asset markets on Thursday, carry trades and emerging market currencies were hit.

Over the week, the yen climbed 3.5% against the sterling, 3.7% against the euro and 2.2% against the greenback. It also rose 4.9% against the New Zealand dollar over the week, in spite of a 0.25% rate hike by the Reserve Bank of New Zealand and gained 4.1% to against the Australian dollar.

The dollar benefited from this turmoil, pulling away from its lows against the euro and the pound sterling. It rose
1.4% against the single currency and climbed 1.5% against the pound over the week.

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