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High oil prices and weak equities would also keep the rupee under pressure

Downward pressures on the rupee are getting stronger. The currency has enjoyed a bull-run for most of this fiscal year on the back strong capital inflows. But it is now being pulled down by a slowdown in inflows, particularly portfolio flows, along with the widening of the merchandise trade deficit. Heavy dollar buying by the RBI in January has worsened the situation.

A combination of these factors has created a situation of dollar shortage in the banking system. As a result, banks are aggressively resorting to buying dollars in the cash and spot market while selling them in the forwards. That, in turn, has led to the depreciation of the rupee against the dollar in the spot market, whereas in the forwards market dollars are now available at a discount to the spot rate.

This cash dollar shortage has persisted for over three successive weeks now and became quiet acute last week. Importers demand for dollars saw the rupee slip sharply against the US dollar on Wednesday. Oil companies, in particular, were buying dollars noting the climb in crude oil prices above $100 per barrel on the same day. In fact, the RBI had to supply dollars to support the rupee. Over the next two days supply of dollars improved on FII inflows and dollar sales by exporters. That helped the rupee recover some lost ground. Over the week, the rupee-dollar pair traded in a range of 39.625 - 40.24 and the rupee finished the week down by 1% against the greenback. And in the forwards market, dollars were available at a discount up all the way up to 7 months.

The rupee is likely to remain on a slippery ground, as long as this dollar shortage persists. The situation will only improve when the dollar supply improves. That would require either a sharp pick-up in capital inflows or dollar selling by the RBI. Neither of that seems likely. The RBI, for one, would perhaps be more worried about the rupee liquidity shortage that develops before the advance tax payments in mid-March. Liquidity in the banking system is already tight and the RBI has been injecting rupee liquidity on a daily basis. In such a situation aggressive dollar selling by the RBI will corner even more rupee funds. The RBI could resort to sell-buy swaps and help tide over the situation.

News from the capital inflow front also does not seem very encouraging at the moment. The FIIs are only reluctantly ramping up their holding of Indian stocks and bonds. The credit market crisis and the US economic slowdown have reduced the investor appetite for riskier assets. And, now with rising inflation, commodities like oil and gold are appearing as more attractive investment options. Thus, even with a strong fundamental story and relatively better valuations, Indian equities remain less attractive. This is adversely affecting the stock market performance and that has a negative impact on the rupee too.

The rupee is also being undermined by record high oil prices. The rupee, therefore, would continue to trade with a weakening bias. This week it could trade in the range of 39.85 - 40.25. The RBI would, however, be wary of a sharp decline in the value of the rupee as that would only add to the strong inflationary pressures in the economy. As per the latest reading, WPI inflation has climbed to 4.35% and is likely to rise further in the coming weeks.

International price action remains favourable for the rupee however. Increasing fears over the prospect of a US recession hit the dollar last week as market participants bet on further cuts in US interest rates.

The greenback suffered after the Federal Reserve downgraded its growth forecasts. Indeed, the minutes from the Fed’s January meeting, released on Wednesday, emphasised that the central bank remained far more concerned about a looming slowdown than increasing price pressures, opening the way for more rate cuts. On Thursday, a surprise weakening in the Philadelphia Fed’s February regional business activity survey emphasised the gloomy picture.

In contrast, surprisingly strong European data, including an above-consensus forecast survey reading of the Eurozone services sector PMI and a strong rebound in UK retail sales, dampened expectations that the European Central Bank or the Bank of England were set to follow the Fed in its aggressive monetary easing.

The US dollar fell 1.1% against the euro over the week, dropped 0.3 % against the pound and lost 0.6% against the yen. It dropped even more against the high-yielding Australian and New Zealand dollars.

This week a number of key US data releases, including the fourth quarter GDP and testimony by the Fed Chairman Ben Bernanke, are due. That will shed more light on the state of the US economy and monetary policy. With the exception of producer prices, more dollar bearish news can be expected. And, there is a good chance that another round of weak US economic data could drive the US dollar to a record low against the euro. Heightened volatility can also be expected in the currency markets, given the heavy US data calendar.

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