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In a week which was likely to be an uneventful one in the financial markets, the US Federal Reserve took an important step towards unwinding its massive monetary stimulus programme put in place to counter the subprime crisis.

In a sign of the Fed’s increasing confidence in the strength of the US economic recovery, the discount rate — the level at which commercial banks tap the central bank for emergency funding — was raised by a 0.25% to 0.75% — above the benchmark federal funds rate. Markets were caught off-guard by this move late on Thursday.

While the move had been well-flagged by the Fed, its timing was a surprise and refocused market participants on worries about how economies and companies will cope as central banks start to withdraw support for credit markets and tighten monetary policy, leading to higher interest rates.

In the currency market, the US dollar leapt to nine-month highs on Friday after the Fed announcement. The greenback spiked higher against the euro and the pound, with the euro losing more than a cent in just minutes.

Over the week, indecisive financial markets kept the currency in a tight range until the Fed surprised markets and raised borrowing costs for banks.

The euro however, finished the week almost unchanged against the dollar, sustaining a drop to fresh year-to-date lows before bouncing into Friday’s close.

The single currency was helped by the Fed statement that a hike in the discount rate did not signal any changes in the stance of the central bank on monetary policy and the crucial federal funds rate.

Since December last year, the greenback has been rising against major currencies, helped by market participants’ unwinding of “carry” trades, where they borrowed cheaply in dollars and invested the proceeds in higher-yielding assets.

Expectations for a stronger economic recovery in the US have raised prospects for interest-rate hikes, perhaps later this year, making the carry trade less profitable.

The pound suffered losses against the greenback after a drop in retail sales raised fears of the economy contracting. Over the week, it lost 1.4% against the dollar and fell by 1.4% against the euro.

In the local inter-bank market, the rupee appreciated a tad against the dollar. The Indian unit gained some ground as the greenback was largely steady for most of the week in the overseas markets. Strong industrial production numbers and improving risk appetite among global investors brought portfolio inflows into local stocks.

FIIs bought stocks and bonds worth $817 million last week.
The stock market was flat over the week, but the news of the Fed hike in the discount rate did have a negative impact, that in turn affected the rupee. Over the week the rupee-dollar pair traded in the range of 45.95-46.49.

For the local market, this week promises to be an eventful one. All attention will be on the Union Budget announcement for the next fiscal, on Friday. Before that, the finance ministry will release the Economic Survey on February 24.

With the economy firmly moving along the path of recovery, powered by the manufacturing sector, WPI inflation approaching double-digits and with the fiscal position of the government significantly stretched, the central government may have to withdraw some of the stimulus provided by the fiscal policy, which may include rollback of discretionary support provided through tax cuts, especially excise duties.

The withdrawal may create some pressure on the stock market, on concerns about the sustaining economic momentum particularly in certain sectors, and that in turn affect the rupee.

Market participants would look for an improvement in the fiscal position of the government, given that foreign investors are particularly sensitive about sovereign debt in light of ongoing fiscal problems involving Greece.

Some fiscal consolidation is expected in the absence of some of the large-ticket spending items like pay commission arrears and on account of better tax revenue growth along with renewed efforts towards disinvestment.

Any efforts on part of the central government to reduce the size of its budget deficit through rationalisation of subsidies and other structural expenditures would be seen as a positive development.

Market participants are expecting the fiscal deficit to fall to about 5.5-5.8% of GDP in the next fiscal from about 6.8% this fiscal. A lower projection of fiscal deficit than consensus expectations would also provide a boost to the market.

Besides the fiscal deficit, the size of the central government’s market borrowing programme will also be crucial.In all likelihood, the size of the borrowing would be as large as this year’s record programme. That in turn can act as a key factor for driving interest rates higher in the economy and thus negatively affect economic growth momentum.

Overall, if the Budget manages to support the ongoing growth momentum and take steps towards dealing with the problems of low productivity in the agriculture sector without straining the
Centre’s fiscal position, then the stock market and the rupee would get a boost.

Any measures aiming to liberalise the FDI regime would also be positive for the rupee. Therefore, a lot hinges on the Budget announcements this Friday and in the run-up to the finance minister’s speech, markets would trade on expectations around the announcements.

Global market scenario would also continue to have a bearing on the rupee. Financial markets will see continue to see some influence of the Fed’s discount rate hike decision and that is likely to support the US dollar. So the rupee-dollar pair could trade in its recent range of 46.00-46.75.

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