Column

Financial market history is being rewritten with asset prices deflating to lower levels everyday. The US sub-prime mortgage collapse driven-credit market crisis has gripped the global financial system.

Risk aversion and de-leveraging are all pervasive. Investors around the world are being forced to liquidate positions in equities, commodities and higher-yielding currencies amid growing evidence that the global economy is heading for a sharp downturn. This is visible in a sharp rally in the safe haven currency, the US dollar, and the carry trade currency, the Japanese yen.

Governments and central banks around the world remained in pursuit of restoration of confidence among investors and the markets, with more efforts going into ensuring normal functioning credit markets and solvent banking systems. More central banks across the world are cutting rates to support their economies.

In this backdrop, the yen surged higher, hitting 13-year highs against the US dollar and pound, and jumping to a six-year peak against the euro as panic gripped global markets and forced investors to abandon risky positions. The rise in risk aversion benefited the low-yielding yen as, prior to the crisis, it had been widely sold to finance the buying of higher yielding, riskier assets.

Last week, the yen rose 9% against the US dollar, climbed 14.4% against the euro and gained 18.5% against the pound. Higher-yielding currencies were also hit hard against the yen, with the Australian dollar on Friday putting in its worst one-day performance in 32 years. Over the week, the yen rose 18.7% against the Australian dollar and climbed 16.5% against the New Zealand dollar.

The US dollar, which like the yen has been used as a funding currency, surged higher as investors unwound positions and returned to cash. The greenback rose 9% to a six-year high against the pound on the week and climbed 5.2% to a two-year peak against the euro. Sterling hit a record low against the euro, as figures on Friday showed that the UK economy contracted for the first time since 1992. The pound, which was hit last week as the Bank of England warned that the UK economy had entered a recession, dropped 4.5% against the euro on the week.

The global financial crisis has reached Indian shores in the earnest now and the rupee’s 25% depreciation so far this fiscal is a manifestation of that. The Indian economy and equities were helped by a sharp pick-up in capital inflows in recent years. Now a rapid withdrawal of foreign capital in a short span on time has led to massive asset value erosion. Last week, the rupee fell to a historic low against the greenback and first time ever, touched a level of 50.

Equity market slide on the back of outflow of capital through the portfolio route and strengthening US dollar together pulled the rupee further down. The Sensex declined by another 12.7% over the week, as FIIs withdrew more funds from local equities. FIIs sold $616 million worth of equities and bonds, taking their total sales in October to $3.4 billion. The US dollar also continued its rally against its major peers.

The Reserve Bank of India (RBI) remained steadfast in its efforts to support the rupee through dollar sales and that helped curtail the extent of rupee depreciation to about 2.2% over the week. Besides direct intervention, the RBI also announced that it would resume special market operations with oil marketing companies when they receive oil bonds from the government. These operations will help ease some pressure on rupee, as oil firms’ demand for dollars will be met by the RBI directly.

The RBI also slashed the repo rate by 1% , thereby easing monetary levers further after it reduced the banks’ cash reserve ratio by 2.5% in the previous week. That, however, failed to cheer the markets, especially the stock markets, thereby failing to provide any support to the rupee. Even otherwise, falling interestrates erode the differential yield
advantage and are therefore unlikely to help the rupee in the medium term.

The government also substantially eased the restrictions on external commercial borrowings to shore up capital inflows, but given the state of global capital markets, that also turned out to be a non-starter.

The force of downward pressures that have taken the Indian currency into uncharted waters looks unlikely to abate in the next couple of months. Risk aversion, de-leveraging and hedge fund withdrawals are all likely to see capital outflows from the portfolio route continuing.

Besides these outflows, dollar liquidity shortage is also exerting pressure on the rupee through the external debt route. As per the latest data, $89 billion worth of India’s external debt is due for repayment by the end of June 2009. Of that, $45 billion is due on short-term trade-related debt and about $33 billion is due to non-resident Indians. Under normal circumstances, short-term trade debt is typically a revolving facility and does not create a funding problem.

But under the current scenario, dollar denominated lines of credit are scarce and therefore it appears that instead of getting rollovers, importers are being forced to retire this debt. That is adding to the pressure on the rupee. The other main downward pressure on the rupee from a stronger US dollar too could persist over the next couple of months.

This week, however, investors’ confidence in the greenback could be shaken. The US Federal Reserve’s monetary policy committee is meeting on Tuesday and markets are fully pricing in another 0.5% cut in the overnight Fed Funds rate.

The other prominent event of the week is the release of advance estimate of third quarter US GDP. Real GDP growth is anticipated to fall to a 7-year low of -0.5% after surging 2.8% in Q2 on robust export growth. There is little doubt that the US is already one foot into a recession (two quarters of contraction make a technical recession), but the long-term strength of the dollar will depend on how shallow the recession is and how quickly it recovers relative to its global counterparts.

These pressures, along with growing downside risks to growth, will see rupee crossing the 50 to a dollar mark in the near term. In fact, the offshore non-deliverable forwards market is now quoting a level of 55 for the rupee-dollar pair in a 3-month tenure. A level half-way from that is quite likely to be reached by the end of this year. This week, the rupee-dollar pair can trade in the range of 49.70-50.50.

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