Comment

Growing sovereign debt default prospects from countries in the eurozone and fears of a contagion severely affected market risk appetite last week. Equity markets and other risky assets slumped as a result. Concerns about Greece’s budget deficit heightened and spread to other countries on the periphery of the eurozone, such as Portugal, Spain and Ireland, which also have large fiscal deficits and high labour costs.

Worries over budget problems within the eurozone were especially heightened by comments from the President of the European Central Bank, Jean-Claude Trichet, on Thursday. Trichet took a tough line on fiscal discipline. He said he approved of Greece’s plans to reduce its deficit. Trichet however, maintained that the ECB’s stance on the European Union’s stability pact, which requires fiscal deficits of less than 3% of GDP for member countries, was ‘inflexible’. Credit default swap prices, which measure the cost of insuring against default, briefly breached record levels on Greece and Portugal on Friday.

While this issue dominated market sentiment for most of the week, market participants were also keenly awaiting the US non-farm payrolls report due on Friday.This most crucial piece of data on the US labour market disappointed as employers in the manufacturing and services sector continued to shed jobs in January against consensus forecast of a small net addition.

Under these conditions of risk aversion, the currency market price action saw momentum being added to the bull run of the US dollar. The greenback surged to its highest level in seven months on a trade-weighted basis, as worries over fiscal problems in Europe boosted safe-haven demand for the dollar. Concerns over the size of Greece’s budget deficit have dogged the euro since January, but those fears spilled over into a broad-based flight from risky assets that saw global equity markets tumble and the greenback push higher across the board.

The dollar index, which tracks its movement against a basket of currencies, rose 1% over the week to its strongest level since July 13. The US dollar hit an eight-month high against the euro on Friday, taking the greenback’s gains during the week to 1.4% against the currency. The dollar also rose 2.3% over the week to an eight-month high against the pound as the UK’s rising fiscal deficit undermined sterling. The greenback rose 1.2% to a five-month high of against the Swiss franc.

The dollar, however, lost ground against the yen as rising risk aversion boosted safe-haven demand for the Japanese currency. During the week the yen rose 1.1% against the US dollar, climbed 2.5% against the euro and gained 3.4% against the pound.

Meanwhile, commodity-linked currencies suffered as raw materials prices slumped because of declining investor optimism. The Australian dollar was the worst hit after the Reserve Bank of Australia surprised the market by not delivering a widely expected increase in its main lending rate after its monetary policy meeting. Over the week, the Australian dollar lost 1.9% to a four-month low against the US dollar while the New Zealand dollar fell 2% to a five-month trough.

In the local inter-bank currency market, the rupee also slipped sharply against the greenback, losing 1.2% of its value over the week. Sharp losses in the stock market and the strength of the US dollar pulled the Indian unit sharply lower. Portfolio inflows though positive, remained a trickle compared to the magnitude seen at the start of this year. Over the week, the rupee-dollar pair traded in the range of 45.935-46.75.

This week too, market momentum will continue to favour the US dollar. The greenback has however, already regained more than 50% of its losses against the euro since its early-December reversal.

As long as the risk aversion trend maintains its momentum, the greenback will benefit but the pace of the currency’s appreciation can diminish. The focus will remain on larger concerns like sovereign debt risk, efforts to curb speculation and the focus on potential points of systemic risk in the financial sector. And, with a relatively light economic release calendar, there may be little standing of the way of such trends.

The US dollar’s broader trend will be defined by the general quality and direction of risk appetite. Among the few definable drivers that can have a meaningful effect on the risk appetite among global market participants are the first estimates of the fourth quarter GDP numbers for the European region and the US Federal Reserve testimony on systemic risks. Other scheduled economic indicators like the advanced retail sales report, University of Michigan consumer confidence survey and trade balance are likely to play a reduced role now.

In the local market, price action in the rupee-dollar pair will continue to be driven by the broad movement in the US dollar itself against other major currencies, which in turn would depend on the market appetite for risk. Among local factors, key data releases could have some influence on the rupee, though they may not be able to counter the broader trend in the financial markets.

The Central Statistical Organisation (CSO) is going to release its advance estimate for 2009-10 GDP on Monday. Industrial production data for December and monthly inflation data for January are also due.

All these data points are likely to point towards growth maintaining momentum but also show that inflationary pressures are gaining traction. This combination is an indication of tighter monetary conditions, but the RBI has already pre-empted that by raising banks’ cash reserve ratio aggressively, thereby reducing the positive impact of rising interest rate differentials.

The stock market environment may also continue to remain unfavourable for the rupee, especially given the slew of equity offerings, driven by government’s disinvestment programme. Overall the rupee-dollar pair is likely to trade in the range of 46.00-46.75 this week, with a bias towards weakening.

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