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Positive developments marked the price action in the currency market last week. The most significant of them was an 11% decline in international crude oil prices. That, along with reassuring financial results from leading US investment banks, helped stoke investors’ risk appetite. A rally in equities of developed economies followed. That particularly helped the dollar recover from a record low against the euro, to finish the week broadly stronger.

The week started badly for the greenback. Oil reached $145 a barrel and global equities fell lower as markets soured after reflecting on the US government’s plan to support the country’s ailing mortgage agencies, Freddie Mac and Fannie Mae.

Market participants rushed to sell the dollar, pushing the price of a euro to a record $1.6038 on Tuesday. The greenback then reversed course. Oil prices fell nearly 10% and some of the biggest US banks posted better-than-expected results, brightening the mood towards the financial sector.

The greenback endedthe week up 0.7% againstthe Japanese yen while the euro softened 0.6% against the dollar.

In the local market, the rupee added to its previous week’s gains against the dollar. It appreciated by about 0.3% over the week, taking total gains to about 1% in the past fortnight.

At the start of the week, however, the local unit was beaten down by rising oil prices and a sharp slide in the equity markets.

News of a downgrade of the outlook for India’s local currency debt rating by international rating agency Fitch added to that pressure.

Mid-week, as oil prices started to fall, the rupee began to recover lost ground. A 1,000-point rally by the BSE Sensex over Thursday and Friday helped it hold on to its gains. Some demand for dollars emerged from importers at lower levels for the rupee-dollar pair. The FIIs also turned net sellers of local stocks and bonds, offloading $259 million worth of Indian assets last week. The rupee-dollar pair moved in wider range of 42.65-43.295/$ over the week.

A lot of the positive sentiment seen across markets last week was driven by the slide in oil prices. Fundamentals of demand and supply are driving the bounce in prices seen over the last three years.

Demand for crude oil from emerging markets like China and India has grown manifold over the last five years, adding to the high levels of consumption in OECD countries, particularly the US.

Supply of oil, on the other hand, has remained stagnant following under-investments in exploration and refining due to low oil prices for most of the 90s.

During the first half of 2008, the supply of oil from non-OPEC producers, which is
about two-thirds of the total global supply, is down by about 1% compared to the same period last year.

At the same time, global oil demand has grown by about 0.9% in the first half of 2008. On top of that, lax monetary conditions in the US since August last year have
provided afurther push to prices through increased speculative activity.

Political tensions inimportant non-OPEC producers like Nigeria also threaten to disrupt supply from time to time. Given these dynamics, crude prices have risen about 50% in the first half of 2008.

Last week’s sharp decline, therefore, came as a relief. Behind the decline were signs that demand for oil could ease on the back of a slowdown in global growth.
Ben Bernanke, chairman of the US Federal Reserve, reiterated his concerns
over economic growth last week. That, along with an increase in US crude oil inventories, triggered the decline in prices.

On top of that, Chinese GDP printed lower during the second quarter of 2008, which helped ease prices even further.

It thus appears that in the short term, oil prices could ease further. Market participants are looking at $120/bbl as a near-term bottom.

Any further downward correction in oil prices will benefit the rupee. Not only will it reduce pressure on the Indian unit, but also improve the sentiment in the equity markets.
However, any dip in the rupee’s value could see importers line up to buy dollars. It also appears that state-run oil marketing companies have run out of oil bonds, which is hampering their ability to buy dollars directly from the RBI.

If these companies come back to the inter-bank market, it would exert downward pressure on the rupee.

This week, the Indiancurrency will also be sensitive to political developments, as the UPA government faces a trust vote in Parliament on July 22. If the government proves itsmajority, it will be broadly positive for the rupee, as there would be no disruption in the macro-economicpolicy environment, which will help boost investorsentiment.

Any other outcome could lead to a period of uncertainty, which will prove negative for the rupee. Overall, the rupee and dollar are likely to trade in the range of 42.50-43 this week, with downside risks.

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