Risk aversion could keep rupee subdued this week

Greece’s sovereign debt problems took centre stage once again last week leading to another bout of risk aversion in financial markets. Concerns over the state of Greece’s public finances intensified, as the European Commission revised the country’s budget deficit higher to 13.6% of GDP on Thursday.

This was almost a full percentage point higher than the Greek government’s projection of 12.7%. Greek government bond yields rose sharply, heightening concerns over Athens’ ability to service its debt.  The 10-year Greek bond yield climbed to 8.8%. Greece has to refinance €8.5 billion in bonds that mature on May 19.

Problems worsened when the after international rating agency Moody’s downgraded Greece’s sovereign rating and said that it might lower it further, citing rising borrowing costs. These developments pushed financial markets into a risk aversion mode. Risk appetite was already running low following the SEC action against Goldman Sachs in the US.

In the currency markets, the euro declined versus the US dollar and the pound last week on concerns over Greece’s finances. The euro was put under further pressure on Thursday.  Selling pressure on the euro escalated in early trade on Friday, sending it down to a one year low against the US dollar and a three-month low against the pound.

The euro found some respite after George Papandreou, the Greek prime minister, asked for the activation of a eurozone and International Monetary Fund aid package worth €30 billion.  Other eurozone countries and the IMF have pledged to bail out Athens if it could not fund its debt obligations in the market. The news helped the euro recover from its lows, but market participants were uncertain that the gains could last. Over the week, the euro lost 0.8% against the US dollar and lost 1% against the pound.

The euro did advance against the Yen however, rising 1.1% over the week as the Japanese currency fell across the board. The yen suffered losses as global bond yields drifted higher in anticipation of central bank exits from ultra-loose monetary policy everywhere except Japan. Over the week, the yen fell 1.9% against the greenback, dropped 2% against the pound and lost 2.3% against the Australian dollar.

The pound eased 0.1% against the US dollar over the week, losing ground on Friday as UK fourth-quarter 2009 GDP growth came in lower than forecast.  Elsewhere, the Canadian dollar climbed 1% against the greenback over the week after the Bank of Canada signaled that it was set to become the first central bank from G7 — the group of seven industrialised nations — to raise interest rates since the onset of the financial crisis.

In the local inter-bank market, the rupee closed the week a tad lower against the US dollar. The currency was subdued by the greenback’s  strength overseas and the general environment of risk aversion among global investors.  The rupee did receive some support from the rate hike by the RBI in its annual monetary policy announcement on Tuesday. FIIs also remained net buyers of Indian equities and bonds, with their net purchases amounting to $707.5 million last week. Overall the rupee-dollar pair traded in the range of 44.36 – 44.74 and the rupee finished 0.2% weaker against the greenback.

Concerns over Greece contributed to the dollar’s gains last week and it also set the benchmark to its sharp correction. Therefore, it is reasonable to expect the same source of activity will continue to drive price action this week. This Greek debt crisis is at the brink of another critical stage. No longer is there doubt that Athens is in trouble with its debt.

If the European Union fails to bail out Greece, it could default, exit the monetary union or find some other unique and painful solution. This will almost certainly hurt the euro and send capital fleeing to its primary counterpart, the dollar. Further, if Greece falters it would likely send credit and financial market ripples across the world. Considering the recent upmove in risky assets, such a catalyst could have dramatic consequences. That being the case, the traditional safe haven — the greenback — will be open to all.

Another important event over the weekend is the economic summit in Washington. The G-7, G-20, IMF and World Bank were scheduled to meet and discuss the economy, financial health and the talk is likely to shift to Greece. Given the highly dynamic nature of markets at this point, it would not be unusual to see a promise relating to international policy.

Market participants will also be looking for confirmation to speculation that the US Federal Reserve is planning to sell off assets on its bloated balance sheet. Such a move would be a hawkish step and pass another milestone to the inevitable Fed rate hike.

A round of major scheduled event risks this week will add to the volatility in the markets. The Fed is unlikely to change its benchmark Fed Funds rate; but market participants would look for a discount rate hike, possible changes to non-standard policy measures and cues on the timing of the Fed rate change from the statement. Offering far better opportunity for clear price action is the advanced reading of the first quarter US GDP data.

Due on Friday, this reading is actually expected to show that the US economy’s robust pace of recovery slowed down as the policy stimulus fuel runs thin. Though expected, such a downshift could significantly cool interest rate speculation.

In the local market, the rupee could continue to remain subdued against the dollar as the Greek debt crisis enters its next stage and the greenback finds support from risk-averse investors. Local stock market action would also continue to have an important bearing on the rupee. Therefore if the equities market comes under pressure on account of global risk aversion or local factors, rupee too could suffer losses. Overall, the rupee-dollar pair would trade in the range of 44.30 – 44.90 this week.

The writer is senior economist, Royal Bank of Scotland NV and can be reached at gaurav.kapur@rbs.com. Views are personal.