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The dollar is in trouble again, as concerns about the health of the US financial system have resurfaced. This time around, it is the government-sponsored mortgage agencies, Freddie Mac and Fannie Mae, who are in trouble.

Between them, these two agencies own or guarantee about half the $12,000 billion of outstanding US home loans.

Last week, concerns on their financial health were sparked by speculation that they might have to raise fresh capital, which could be very difficult.

With concerns on the health of the US financial system at the forefront again, it will become even more difficult for the US Federal Reserve to raise rates. Currency markets were quick to factor that in last week, when the greenback fell by 1.5% against the euro and finished the week very close to record high level of $1.60 to a euro. It also fell against other major currencies, including the Japanese Yen and the Swiss Franc.
In the local inter-bank market, the rupee also strengthened against the dollar by 0.6%. A sharp decline in oil prices early in the week triggered a rally in the equity market.

The first half of the week also saw sizeable inflows by the FIIs, who were net buyers of Indian equity and debt last week. That brought in $589.4 million over the week. The pressure on the rupee from the offshore non-deliverable forwards market also subsided on the back of a sharp decline in the value of the greenback overseas. These conditions helped improve overall market sentiment towards the rupee, prompting banks to unwind their long dollar positions mid-week.

However, towards the end of the week, oil rallied again, pulling down equities and the rupee. Over the week, the rupee-dollar pair traded in a wide range of 42.705-43.49 and the rupee closed below the 43 level against the greenback.

This week, a lot will depend on what happens to the dollar. Continuing speculation about future of the two mortgage agencies will undermine the greenback.

Any indication that the US government will bail them out will help restore market confidence, improve risk appetite and help the greenback. However, that might not be the best possible outcome for the greenback over a longer term, as a government bail-out of these agencies could lead to a deterioration of the US public finance situation and that in turn could even lead to a credit-rating downgrade of the US economy.

Economic data releases from the US this week will be closely tracked too, as some significant numbers are due for release. These include retail sales, producer prices, consumer prices,industrial production, the US treasury’s International Capital Flow report, housing starts and the minutes from the last FOMC meeting.

Retail sales, a critical gauge of consumer spending, have been resilient in the face of multiple pressures on the US consumer’s spending power. A sharp slip in retail sales growth, compared to the 1% month-on-month increase in May, would definitely add to pressure on the greenback.

However, consumer price inflation data is likely to be supportive for the dollar, as growing inflationary pressures, especially through rising oil prices, are likely to push inflation higher. Overall, it appears that the greenback would suffer more losses this week.

The impact of any dollar weakness on the rupee islikely to be limited. A sharp
depreciation of the green-back will push up oil prices past the $150/bbl mark and
that will only accentuate the trouble for local stocks and the rupee.

The risks to the rupee from a moderation in capital inflows could also intensify in the near future.

Foreign investor sentiment towards the Indian economy has worsened significantly over the last quarter. That has been visible mainly in an exodus of FII funds from the equity space. Last week, the international rating agency S&P also pointed out that risks to India’s investment-grade rating are increasing and any further deterioration could lead to a rating downgrade. These risks include rising fiscal deficit, rising inflation and widening current account deficit. While a rating downgrade looks unlikely over the next 3-6 months, the overhang of these risks does not augur well for investor sentiment and capital inflows.

RBI support will, therefore, remain very critical in arresting any slide in the value of the rupee.

The Indian central bank holds reserves of over $308 billion and can keep a lid on rupee depreciation, especially as inflation is likely to head higher.

Last week, the South Korean central bank, Bank of Korea (BoK), showed the way to other Asian central banks fighting inflation. It sold about $2 billion on Tuesday and more than $3 billion on Wednesday, as it tried to support the won, which has fallen 10% in the first half of the year. BoK said it would use its foreign exchange reserves—estimated at $258 billion—again to stabilise inflation, adding that it would continue to defend the won’s 1,000 level against the dollar. As a result of BoK support, the won notched its strongest weekly gain in 10 years.

In case of India, while it will be difficult for RBI to fight the worsening external fundamentals, it can certainly keep a lid on the extent of rupee depreciation.

With inflation likely to rise to 14-15% by September, every possible tool will have to be used to check price rises. As far as this week goes, the rupee can hold its ground against the greenback and the pair can trade in the range of 42.50-43.00.

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