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Last week was a stellar one for the rupee. It appreciated by close to 3% against the US dollar over the week, making it the best performing emerging Asian market currency. The rupee rally was triggered by the sharp depreciation of the dollar, especially against other Asian currencies. The Indian unit has been a laggard in recent weeks in Asia and the rally last week was to some extent a catch up with regional currency movements.

The divergence between the rupee’s recent moves vis-à-vis other Asian currencies created a strong appreciation bias for the Indian unit in the offshore market. At the start of the week, an arbitrage opportunity was created between the onshore and offshore forwards market, which favoured rupee appreciation in the onshore market.That drove rupee’s sharp gains during the first four days of the week.

The rupee also got the support from rising inflows of portfolio capital. FIIs bought over $1 billion worth of local stocks and bonds. RBI governor’s D Subbarao’s comments that interest rates could be raised ahead of the major countries, as inflationary pressures were gaining traction, also gave a boost to the currency.Last week, the rupee-dollar pair traded in the range of 46.20-47.65. The RBI did not intervene in the market to prevent the rupee’s appreciation. In the international market, the US dollar was sold-off aggressively last week, prompting some Asian monetary authorities to actively participate in foreign exchange markets to stem the tide. The dollar index fell to a 14-month low on Thursday.

Initial losses for the greenback were prompted by the Reserve Bank of Australia, which on Tuesday became the first major central bank to raise interest rates since the onset of the financial crisis. The central bank lifted rates from an historic low of 3% to 3.25%, saying the move reflected resurgent growth and inflation moving closer to target levels.

The tightening contrasted sharply with the current stance at the US Federal Reserve, that has reiterated at every policy meeting since it lowered its rate to 0.25% in December, that economic conditions were likely to warrant exceptionally low levels of the federal funds rate for some time. The Australian dollar rallied 4.5% over the week, hitting a 14-month high on Thursday, amid widespread expectations for further increases.

Comments from Japan’s finance minister, Hirohisa Fujii, were also unhelpful for the greenback. He claimed that the weakening US dollar was being met with a sense of crisis in the US. Meanwhile, Lawrence Summers, chief economic adviser to the US president, stressed the importance of the US stance for a strong dollar, echoing recent sentiment from US Treasury Secretary Timothy Geithner.

The Australian central bank’s move led market participants to speculate on which country might be next to raise rates. Other countries with similar resource-rich or export-oriented economies, such as New Zealand, Norway, Canada and South Korea saw their currencies in favour. Over the week, the New Zealand dollar climbed 2.6%, the Norwegian Krone gained 2.7%, the Canadian dollar rose 3.2%, and the South Korean won appreciated by 1.5%. South Korea’s central bank, Bank of Korea (BoK), however, opted not to lift interest rates at its policy meeting last week.

Efforts by the BoK and other Asian central banks on to stem the appreciation of their domestic currencies by purchasing dollars in the foreign exchange market met with limited success. In spite of intervention, the Thai baht gained 0.4% over the week, Taiwan’s dollar nudged up 0.1% to and the Indonesian rupiah climbed 1.9%.

Policy meetings at the Bank of England (BoE) and the European Central Bank (ECB) were relatively uneventful. The BoE left rates at a historic low of 0.5%. It decided to wait and see if the exceptional measures already taken could do anything to turn around a recent run of dismal economic data. The ECB, after leaving its key rate at 1%, added to the global chorus warning about the impact of the weaker dollar. The pound had a volatile week against the greenback and fell by 0.7%. It fell 1.7% against the euro. The euro climbed 1.1% against the US dollar. After last week’s action in the rupee-dollar pair, we could see some consolidation in the pair during this week.

The arbitrage between the offshore and onshore forwards market is largely closed. The equity market conditions could also act to put some pressure on the rupee, considering investor concerns of overvaluation of the local market. The second quarter corporate earnings data would be crucial to watch here, as that could create some volatility in the markets.

However, rising investor appetite for risk along with dollar funded carry trades back could see portfolio flows especially in local debt to remain buoyant. Market participants will watch out for the actions of the RBI. The Indian central bank has so far refrained from intervening in a meaningful way to curb rupee appreciation. The RBI is being constrained by the excessive rupee liquidity conditions in the banking system, as any large-scale intervention will only add to that pile.

That is not desirable at a time when supply-side pressures on inflation are also getting some support from improving demand conditions. Hence RBI’s decision to intervene has to be balanced with liquidity removal measures. If appreciation pressures on the rupee build up due to rising capital inflows, then RBI could chose to tighten liquidity by increasing the cash reserve ratio or ceasing its open market purchases of government bonds.

Another instrument which the RBI could use is to enter into sell-buy swaps, thereby negating the rupee liquidity impact of its action. These swaps help curb spot rupee appreciation but drive up the rupee-dollar forward premiums.

While the RBI does face a dilemma in active intervention in the market, it would be forced to intervene if the rupee comes under sharp appreciation pressure like last week. A stronger rupee has limited impact of curbing inflation but tends to undermine export competitiveness. Besides the rise in volatility in the rupee-dollar pair could also invite some counter-action by the RBI. Overall the rupee-dollar pair could trade in the range of 46.10- 46.75 this week.

The writer is senior economist, ABN Amro Bank .Views expressed are personal.