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The rallying US dollar took a breather last week after four consecutive weeks of hefty gains. Market participants decided to book profits on their long dollar positions, noting the sharp upward and perhaps excessive move in the greenback, especially over the last fortnight.

Moreover, concerns about the health of the financial sector in the US were at the forefront again. Share prices of mortgage agencies, Freddie Mac and Fannie Mae, plunged amid talks of a possible government bailout for them. That squeezed investor risk appetite across the globe, pulling down the equities market and the greenback, too. Crude oil prices also rose over the week, following heightened geo-political tensions involving Russia, adding to the pressure on the greenback.

At the start of the week, the greenback continued to benefit from growing evidence and conviction that credit crunch and its ill-effects were spreading outside the US across major economies more strongly than previously thought. The dollar index, which tracks its value against a trade-weighted basket of six major currencies, rose to a seven-month high on Tuesday.

The US dollar also hit a six-month high against the euro on the same day but struggled to maintain its gains later in the week. Market participants decided that the move in the greenback has been too rapid and called for some profit-booking and consolidation.

Over the week, the greenback lost 0.7% against the euro, fell 0.4% against the yen and dropped 0.3% against the Swiss franc. The greenback also underperformed against commodity-driven currencies, losing 0.7% to against the Canadian dollar on the week and dropping 0.5% against the New Zealand dollar.

The US dollar advanced against the pound, however, rising 0.8% over the week as data on Friday showed the UK economy grinded to a halt in the quarter ended June. That undermined expectations of a 0.2% rise in the GDP and was the weakest reading since the second quarter of 1992, when the British economy was in its last period of recession. This heightened speculation that interest rates in the UK are headed lower.

The pound also fell 1.5% against the euro on the week and lost 1.2% against the yen as a result.

In the local market, the rupee fell further against the US dollar. Rise in oil prices, falling equity markets, inflation at a 16-year high and a bleak outlook for capital inflows brought to the fore the weak external fundamentals for the local unit. In terms of market action, demand for dollars remained strong, as bank and importers remained net buyers of greenback, noting its strength in the overseas market.

An arbitrage opportunity between the onshore market and the offshore non-deliverable forwards market also added to that demand. FIIs also offloaded Indian equity and debt worth $421.7 million over the week. These pressures saw rupee falling to a 17-month low against the greenback on Monday.

The RBI stepped in and sold dollars on Wednesday when the rupee-dollar pair touched 43.80-43.85, thereby restricting rupee’s losses. Towards the end of the week, FDI inflows and a decline in oil prices helped curb rupee’s losses. Over the week, the rupee-dollar pair traded in a range of 43-43.86 and the rupee depreciated by 1% against the US dollar.

Going forward, the fortunes of the rupee depend upon capital inflows, oil prices and the strength of the greenback. The US dollar may maintain its newfound strength, as other major economies outside the US struggle with an acute loss of growth momentum and seem likely to cut rates. The Euro-zone and the UK are the main contenders here. On the other hand, the US Federal Reserve’s next move will most likely be a rate hike.

However, the interest rate futures market does not expect that to happen until March 2009. In the meantime, the greenback is susceptible to the possibility of the US economy slipping into recession and more bad news from the financial sector. The US dollar could, therefore, remain volatile but its overall strong position will be negative for the rupee. This week, the greenback could rise again on the back of a likely upward revision to the second quarter GDP growth data.

A positive for the rupee will come from improvement in capital inflows and invisible inflows such as inward remittances from non-resident Indians, towards the second half of the fiscal. Among capital inflows, foreign direct investments (FDI) could pick up.
In the first quarter of the fiscal, even as portfolio investors withdrew funds from India, gross FDI inflows amounted to $10 billion. With the likelihood of a better policy environment and given the solid long-term growth prospects of India, FDI inflows could improve. Even portfolio investments could pick up as the government intends to restart the process of selling its stake in some of its entities.

Oil prices remain the most crucial driver for the rupee’s value. Both US dollar strength and a decline in energy consumption in developed economies on the back of an economic slowdown will help keep oil prices in check. However, strong demand from emerging economies, speculative activity and geo-political tensions will keep prices from falling sharply. On balance, oil prices could remain at current levels for some time.

Overall, the general global environment and the external fundamentals of the Indian economy remain biased towards a weaker rupee. The RBI too seems keen to correct only a sharp decline in the value of the rupee and will provide support mainly to the extent of providing dollars for lumpy demand from oil companies and other importers. This week too, the rupee will, thus, remain under pressure and the rupee-dollar pair is likely to trade in the range of 43.00-43.50.

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