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Weak equities, strong US dollar and high oil prices could undermine Indian currency

The rupee’s strength could be put to test this week. Market conditions are turning adverse for the Indian currency. Foremost among them is the persistent weakness in the local equity market.

Last week, the benchmark BSE Sensex fell by 4.3% and two companies withdrew their ongoing initial public offers, citing volatile market conditions which are leading to a lack of investor interest.

Besides hitting the sentiment, this could also squeeze the inflow of dollars into the country, as in the recent past, IPOs have seen good foreign institutional investor participation.

Global market environment also remains unfavourable for equities in general. Risk aversion remains well entrenched in the market psyche in the face of a US economic slowdown and the turbulence in the credit markets.

Last week, equities lost more value across the globe. Therefore, with a risk of further slippage looming large in the equity markets and FIIs remaining largely at the sidelines, local market participants would be wary of going short on the US dollar.

The other crucial downside risk that the rupee faces is from a correction in the US dollar. Last week the greenback trounced all major currencies, particularly the euro. In fact, the euro endured its worst week in 18 months against the greenback, just a week after coming close to its record high.

While a lot of the bad news about the US economy has already been priced in and is reflected in the value of the greenback, contagion in the euro zone from a US downturn has not been fully recognised by the currency market.

Also, with the European Central Bank signalling last week that it is worried about growth and is likely to cut rates in near future, the euro would come under increasing pressure.

The euro’s slide started last Tuesday after a survey suggested that the activity in the euro zone services sector slowed markedly in January.

The Euro-zone Services Purchasing Managers’ Index for January was revised down from 52.0 to 50.6, its weakest level since July 2003. The readings for Germany, Italy and Spain plunged below 50, which indicates contraction, with only France bucking the trend of the big economies.

That data fuelled talks that the ECB would have to give up its hawkish stance on interest rates. The central bank did not disappoint. On Thursday the ECB kept euro zone interest rates on hold at 4%.

But Jean-Claude Trichet, ECB president, softened his previous stance of “pre-emptively” raising interest rates to curb inflation. He warned instead of the downside risks to growth posed by financial turbulence and a slowdown in the euro zone’s big trading partners.

The euro sold off sharply on the news, and market participants expect this trend to continue. Over the week, it fell 1.9% against the US dollar, lost 1.3% against the Japanese yen and dropped 1% against the British pound.

Meanwhile, the pound also fell 1% against the greenback over the week, undermined by the Bank of England’s decision to cut interest rates a quarter-point to 5.25% on Thursday. The central bank said it took the decision in the light of deteriorating prospects for global growth and tightening credit conditions.

The greenback also gained against the carry trade funding currencies, the yen and the Swiss franc.

The Indian unit also lost 0.7% against the US dollar last week, on the back of a slide in equities and a shortage of dollars in the inter-bank market.

Overall, it appears that market participants could readjust their bets in favour of the greenback in the coming weeks. This week, the greenback would be tested by the US retail sales data, the main indicator of consumer spending.

However, unless the data is very weak, the greenback is unlikely to see a major decline, as market participants now consider that the US economy is already in recession. In terms of data releases, this week is more crucial for the euro, as the euro zone GDP data will be released.

Weaker-than-expected data would only add to the downward pressure on the currency.

In the local market, a spiral in crude oil prices above $90 per barrel would only further the cautious sentiment on the rupee. Scales are clearly tipped against the Indian unit and it could slip further this week while the rupee-dollar pair could trade in a range of 39.50 - 39.85.

The RBI, however, is likely to prevent a sharp slide in the rupee, as a weaker currency adds to the already strong inflationary pressures. The headline inflation has risen above 4% and is on its way up.

Last week the rupee-dollar forward premiums in the near tenors tipped into a negative territory (or a discount). Payments to FIIs of their Reliance Power IPO over-subscription amount and the lack of a matching fresh dollar supply, created a situation of cash dollar shortage in the inter-bank market.

That forced banks to enter into buy-sell swaps in the spot and forwards markets respectively, pushing down the premiums into discount in the 1 month tenor. The situation improved towards the end of the week.

Forward premiums in general are likely to remain biased upwards, as interest rate differentials between India and the US are poised to widen in the near-future.

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