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The world economy is slowing down rapidly with leading developed economies now in recession. Third-quarter data released on Friday confirmed that the Euro-zone had sunk into recession for the first time since the start of the single currency in 1999.

The Euro-zone economy shrank 0.2% in the second and third quarters of FY09 compared with the respective previous quarters, bolstering expectations of more interest-rate cuts by the European Central Bank. In the US, retail sales dropped 2.8% in November, recording their largest monthly drop yet and pointing to a sharp fall in consumer spending in the fourth quarter.

The Bank of England, which delivered a 1.5% cut in interest rates in the week before last, said the UK economy had fallen into recession and signalled more rate cuts. Data also revealed bigger-than-expected drop in industrial output in China and Japan.

Against this backdrop, risk aversion increased among investors and global equity markets fell further as deleveraging continued. Besides deteriorating economic data, renewed fears over the outlook for the financial sector after the US Treasury shelved plans to buy toxic mortgage-backed assets also affected sentiment negatively.

In the currency market, the US dollar and the Japanese yen appreciated over the week while the pound suffered yet another week of sharp decline in value. The pound tumbled to a record low against the euro and dropped below the level of $1.50 against the greenback for the first time in six years.

The pound also fell to its lowest level in 13 years on a trade-weighted basis after the BOE hinted at more aggressive rate cuts. Adding to the pressure were increasing signs that international investors were withdrawing funds from UK assets after aggressive selling of government securities since mid-September.

The pound fell 6% against the US dollar over the week, dropped 5.4% versus the euro and lost 7.2% against the yen.

Meanwhile, the yen and the US dollar were the main beneficiaries, as fears over a sharp slowdown in the global economy triggered further deleveraging in asset markets. US and Japanese investors liquidated assets that had previously been funded by selling the low-yielding currencies and repatriated cash. Over the week, the greenback rose 0.8% against the euro, gained 1.4% on the Swiss franc and was up 3.9% against the Australian dollar. The yen fared even better, climbing 1.4% against the US dollar on the week, rising 2.2% against the euro and gaining 5.2% against the Australian dollar.

In the local interbank market, rupee also depreciated against the greenback by 2.8% last week. Sharp decline in the stock market, along with the dominance of the US dollar in the global market, prompted market participants to add to their long dollar positions. The BSE Sensex dropped by 5.8% over the week. The RBI had to aggressively support the rupee through dollar sales, especially as it fell very sharply mid-week.

Price action in the offshore non-deliverable forwards market also continued to affect the rupee negatively. The only positive development was the slide in oil prices by 6.4% over the week to close below the $60 per barrel mark. The rupee-dollar pair traded in the range of 47.16-49.48 over the week.

Evidence of the impact of the global slowdown on India also affected the Indian unit negatively. The commerce ministry announced that merchandise exports for October 2008 dropped by 15% against October 2007.

Shrinking external demand will adversely affect the rupee, as despite a drop in commodity prices and the imports bill, the country’s trade deficit can remain around $10 billion a month — the average so far this fiscal. Even on the services side, software exports are likely to see much slower growth on the back of a recession in the US. That too will add up in the form of a larger current account deficit to be funded this year.

On Saturday, the RBI announced more measures to boost dollar liquidity in the Indian economy. The central bank has raised the interest rate ceiling by 0.75% on the non-resident Indian deposits to attract more dollar inflows through this route. Interest rate on these deposits is a crucial determinant of the magnitude of flows and this latest rate increase will help boost inflows going forward. In the first half of the fiscal, net inflow through this route has been $787 million compared with a net outflow of $78 million in the same period last year.

Other measures announced include allowing housing finance companies to raise short-term foreign deposits and allowing prepayment of foreign currency convertible bonds trading at a discount. These FCCB prepayments will have to be funded through local resources or through raising funds via external commercial borrowings route. These two measures are unlikely to prove useful in improving capital inflows in the near future, as global capital markets are in a state of risk aversion.

The RBI also announced measures to boost rupee liquidity in the banking system and to provide greater credit support to the exports sector. Greater availability of rupee export credit refinance to banks will help improve the flow of credit to the exports sector and keep the sector competitive in these challenging times.

This week the rupee is likely to remain under pressure on the back of deleveraging and risk aversion. Stock market movements and the US dollar strength will both act to keep the pressure on the Indian unit. The recent moves by the RBI are likely to provide little support to the rupee. Overall, the rupee-dollar pair may trade in the range of 48.80-49.70 this week. Receding oil prices seems to be the only positive for the rupee at the moment.

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