Column

Downward pressures on the rupee are intensifying. The biggest near-term risk to the rupee’s strength is a slowdown of capital inflows at a time when the trade deficit is ballooning due to record high crude oil prices.

Portfolio investors’ purchases of local assets, particularly equities, have been the major source of capital inflows this year. Their purchases so far in 2007 have amounted to $17.7 billion. In November, however, the FIIs have been net sellers and last week their sales amounted to $1.1 billion.

The prospects of these inflows, at least till the US Federal Reserve’s December meeting, do not look too bright. With risk aversion now firmly entrenched in the minds of investors across the globe, riskier assets, particularly equities are being shunned. Also, capital inflows into India from sources other than portfolio investments too seem to have slowed down.

At the same time, the trade deficit continues to worsen, mainly on account of soaring oil prices. As per latest data, trade deficit in the first half of the current financial year rose by 42% year-on-year to $37 billion.

The situation would have worsened in the third quarter with crude oil rising sharply since October. For instance, the average price of India’s imported crude oil basket has risen from $69.3 per barrel in the first half of the financial year to $79.3 in October and further to $88.9 in November.

Such escalation in oil prices was ignored by the market participants, as they were confident that robust capital inflows would take care of the widening trade gap. Now, with inflows showing some moderation, oil prices are becoming a cause for concern, at least in the near-term.

As a result a large section of the market now expects some decline in the value of the rupee over the next month. These expectations could actually squeeze out the supply of dollars further, as exporters could hold back on their dollar sales and perhaps even cancel some of their forward dollar sales.

That in turn would create demand for dollars in the spot market. At same time the importers could be looking to step-up their dollar purchases. This week, in fact, oil companies would be heavy buyers of the greenback, as the month-end is approaching.

These depreciation pressures were clearly at play last week, when the rupee fell by about 1% against the US dollar, after the pair traded in a range of 39.26 - 39.71.

Large demand for dollars from oil companies and the FIIs pulled the Indian unit down. The RBI also bought dollars quiet actively. Market sentiment was bearish too, as the equities market was on a slide throughout the week and the BSE-Sensex lost 4.3% over the week.

While downward pressures are engulfing the rupee, they would be countered by the acute weakness in the US Dollar. Last week, the greenback fell to record lows against the euro and the Swiss franc and hit its weakest levels for 2-1/2 years against the yen, as speculation mounted that the Fed would be forced into cutting interest rates.

Relentless flow of negative news from US banks and retailers and the weakening outlook for technology companies weighed
on the greenback. The bearish mood was exacerbated by the Fed on Tuesday as it expressed concern over the possibility of a sharp downturn in economic growth.

While the greenback weakened all week, its decline was sharpest on Friday, as liquidity dried up due to the holidays in the US and Japan. However, after its slump, the dollar recouped some of its losses following comments from officials of the European Central Bank.

Miguel Angel Fernandez Ordonez, an ECB council member, said world financial turmoil threatened a stronger-than-expected slowdown in the euro-zone, while the ECB president said “brutal” movements in the foreign exchange market were unwelcome.

Over the week, the greenback fell 1% against the euro and dropped 1.4% against the Swiss franc.

The dollar plummeted 2.5% versus the yen, hitting its weakest level since May 2005. The yen also advanced against other currencies. Weakness in global equity markets heightened risk aversion and saw investors shy away from carry trades.

A report from the OECD that said losses caused by the meltdown in the US mortgage market could hit $300 billion and that the credit crunch had yet to inflict damage on equity markets, also boosted demand for the yen.

This week too it seems that the greenback would trend lower, as declining yield differential and risk aversion would sustain weakness in the currency for sometime.

Interest rate futures are fully priced for a 25 basis points cut in Fed funds rate next month, and more rate cuts in next year. And, with the Chinese government under renewed pressure to allow faster yuan appreciation, this time from the euro-zone, we could see a stronger Chinese currency. That is turn is positive for all other Asian currencies.

In the local market, a mood of caution will prevail, with scales clearly tipped against the rupee at the moment. The
rupee-dollar pair could therefore trade in a range of 39.50 - 40.00 this week.

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