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Amid mounting concerns over global credit markets and with clouds of gloom gathering over the equities market, some positive developments unfolded for the rupee this past week. The RBI, in its quarterly monetary policy review, announced the removal of the Rs 3,000 crore cap on the amount it absorbs through its daily reverse-repo transactions.

This cap, which was put in place on March 5, along with a build-up ofsurplus rupee liquidity in the banking system, resulted in a sharp decline in the shorter tenor interest rates in July. The overnight call money rate, in particular, fell to unprecedented levels.

After the removal of this cap from August 6, the RBI will drain out the excess cash on a daily basis and will pay 6% for it. The overnight call money rates are thus likely to rise towards this rate. That is because banks’ with excess cash would lend it to the RBI at 6% and it therefore becomes a floor level for the call money rate. Other shorter-tenor rates will also rise.

The overnight rate held below 0.5% for most of July and that was imposing a negative carry cost on the banks for holding short dollar positions. This cost was discouraging them to hold large positions and in the process was keeping a lid on the rupee strength. But now with the likely upward movement in the call money rate from this week, a positive carry would be restored.

This is because the interest rate differential between the local overnight rate and the USD LIBOR would become positive again. And, that would help banks’ to stay short on the greenback and long on the rupee. Rising interest rate differentials would push up the forward premiums, too.

The other significant policy announcement was the hiking of the bank’s cash reserve ratio (CRR), from 6.5% to 7%. This measure would suck out Rs. 16,000 crore from the money market and will add to the upward pressure on rates. On one hand, this measure is helpful for the rupee, but on the other hand a higher CRR also enhances the RBI’s ability to intervene in the currency market.

A higher CRR helps in absorbing a larger portion of the fresh rupee liquidity injected by the RBI whenever it buys dollars. Therefore the central bank can intervene and also keep a check on the supply of money.

A CRR hike, besides reducing the stock of money, also brings down the money multiplier (ratio of broad money to reserve money), and has a lasting contractionary impact on the money supply growth. At the moment, broad money supply in the economy is growing faster than the RBI target of 17 - 17.5% for this fiscal, and that tends to stoke inflation.

Helped by these positive announcements the rupee recovered from a 615 point decline in the Sensex on August 1 and a net sale of Indian assets worth $754.8 million by the FIIs last week. Over the week, after trading in the range of 40.32 - 40.62 versus the greenback, the rupee appreciated by 0.4%.

Market participants paid little attention to the trade data for June released on Thursday. The trade deficit in the April-June quarter at $20.6 billion ballooned by 74% over the same quarter last year.
This was because import growth at 34.3% far outpaced the exports growth of 18.1%. This trend of rising trade deficit is likely to persist going forward and will have a significant negative impact on the rupee.

For one, oil prices have risen sharply in July and are unlikely to ease in the near future. This will push up the oil import bill, which has just grown by 4.2% in the first quarter of the fiscal. That combined with robust non-oil imports growth momentum will ensure that imports continue to outpace exports. Growth in exports is being hurt by the loss of competitiveness on account of a stronger rupee.

This week, while the positive market sentiment would underpin the rupee, strong pressures are likely to keep it down.

While equity markets could remain caught up in the risk aversion mood among investors, high oil prices remain a more certain risk. The RBI vigilance towards rapid rupee appreciation is likely to continue, too. Overall the rupee-dollar pair could trade in the range of 40.25 - 40.60.

In the international market this week, the focus will be on the US Federal Reserve’s rate decision. While the Fed is likely to keep the rates unchanged, its accompanying statement assumes particular significance in the back-drop of sub-prime mortgage troubles and some weakness in the recent US data, especially the employment numbers and the services sector activity.

The Fed remains concerned about inflationary pressures in the US economy and a reiteration of that stance would imply unchanged rates for some more time.

However, any hints that is now getting worried about the pace of economic activity, would fuel expectations of a rate cut in 2007 and will further hit the greenback. It remains on a shaky ground and under-performed the other majors last week.

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