Comment

The Union Budget announcement, in conjunction with a rise in risk aversion globally, brought the rupee’s recent strong run to a halt.

The Indian rupee depreciated by 2.3% against the US dollar last week as the stock market tumbled by 9.4%, registering the worst performance in more than eight months.

The trigger for this sharp fall in the equities market and the rupee was the market’s disappointment over the Budget. A large section of the market was disappointed by the absence of any major reform initiatives and lack of clarity on the privatisation of public sector companies. Expectations had built up after the Economic Survey suggested a number of reforms, including aggressive disinvestment targets and raising of FDI limits in insurance, retail and other sectors.

The Budget also did not impose any kind of time-bound commitment for reducing the fiscal deficit. The fiscal deficit for the year has been pegged at 6.8% of GDP, up from 6% last year.

Similarly, financial sector reforms found no mention, which can enable the economy to shore up domestic resource mobilisation and help in maintaining soft interest rates. Market’s disappointment with the Budget was visible in more than 850 points decline in the BSE Sensex and the 1.4% fall in the value of the rupee post the budget announcement on Monday.

The Budget proposals did, however, have all the essential elements to maintain India’s position as an attractive destination for foreign investors, particularly the FIIs, in the short as well as the medium term. With greater public spending allocated to infrastructure and the UPA flagship schemes, especially the successful national rural employment guarantee scheme, the finance minister provided another fiscal stimulus, which is largely focused on improving the productive capacity of the economy over the medium term and supporting rural consumption. The thrust to private consumption through tax relief to individuals would also be helpful in providing momentum to growth in the short term. These steps would help attract more portfolio inflows over a period of time.

Similarly, introduction of a new direct tax code in the next 45 days, implementation of a nationwide goods and services tax (GST) by April 2010 and the removal of FBT are aimed at simplifying the tax code by removing the multiplicity of indirect taxes and making direct tax regulations simple. These are critical steps from the perspective of attracting greater foreign direct investments as they would in help in improving the business environment in the country.

Going forward, the ebb and flow of global investor risk appetite would continue to guide the movement of the rupee. The Budget has delivered a supportive investment environment for foreign investors, which would be helpful for the Indian rupee, if the risk appetite remains strong.

Last week, the global financial markets saw rising risk aversion. That prompted volatile price action in the currency market and the yen surged to a five-month high against the US dollar. Nervousness over the health of the global economy and the onset of the third-quarter corporate earnings season triggered a surge in haven demand for the Japanese yen on Wednesday. The yen surged on safe-haven demand as investor confidence was knocked by tumbling oil prices, falling bond yields and retreating equities and commodity prices.

Over the week, the yen surged 3.7% against the US dollar, its strongest level since February, gained 3.9% to a seven-week high against the euro and climbed 4.5% against the pound. The yen rose more aggressively against the Australian dollar, up 5.9% over the week.

Falling investor sentiment also hit emerging market currencies, sending the South African rand down 3.7% against the US dollar over the week, the Brazilian real 3.2% lower and the Turkish lira 1.4% weaker.

Market nervousness also boosted haven demand for the US dollar. However, the greenback’s gains were tempered by worries that the US dollar’s reserve status might be up for discussion at the G8 meeting of global leaders in Italy. The dollar showed little reaction to comments apparently aimed at its dominance. Although he did not name the dollar directly, Dai Bingguo, Chinese state councillor, called for the world to diversify the reserve currency system and aim at relatively stable exchange rates among leading currencies. The US dollar rose 0.2% against the euro over the week and gained 0.9% against the pound.

The pound fell 0.6% against the euro over the week. However, the weekly move belied a volatile week in which sterling fell sharply ahead of the Bank of England’s policy meeting on Thursday. The pound fell on expectations that the BOE would announce an expansion of its quantitative easing programme on Thursday. But sterling rebounded after the BOE said it was keeping its asset purchase programme target unchanged at £125 billion.

This week, rupee’s movements will depend on the risk appetite of global investors. Any economic data releases supporting the case of recovery in global economic activity, especially in the US and the eurozone, would help strengthen the risk appetite. The key US releases this week include the minutes of the last FOMC meeting, advanced retail sales, industrial production and housing starts.

These data will offer a status check on three essential drivers of growth — consumer spending, the state of the housing market and the manufacturing sector. Any positive surprise could help stoke risk appetite. Otherwise market participants at large remain risk averse, particularly after the grim US employment data on July 2.

That is not helpful for the equities and therefore, the rupee. This week, the rupee-dollar pair could trade in the range of 48.50-49.20. Sharp decline in oil prices last week is helpful for the rupee in keeping the trade deficit manageable, given that the exports continue to shrink.

The author is senior economist, ABN Amro Bank. Views are personal.