Dubai debt crisis to keep rupee under pressure

Volatility of the kind not seen since the dark days of the credit crunch, returned to financial markets last week after doubts were raised about the stability of emerging market debt.

It should have been a relatively quiet week with the US on holiday from Thursday onwards for Thanksgiving. But the lack of US market volume only exacerbated volatility in the markets on Thursday after Dubai asked creditors of its Dubai World holding company for a six-month moratorium on debt repayments. This raised the spectre of sovereign default and reminded market participants of the risks of investment in emerging economies that run huge deficits.

On Thursday and Friday, many emerging market currencies sold off sharply. The South African rand was down nearly 3% against the dollar, while the Turkish lira fell 2.4% and the Hungarian forint shed 3.1%. The squeeze in risk appetite saw unwinding of carry trades and higher yielding currencies like the Australian and New Zealand dollars fell back over the last two days of the week — the Aussie down 1% versus the US dollar and the Kiwi off 1.9%.

Before the Dubai fallout last week, risk trades were given the green light on Tuesday after minutes from the US Federal Reserve’s monetary policy meeting revealed slight forecast adjustments towards greater optimism for growth, while appearing less worried about inflation.  That was taken as a reiteration of the market view that the Fed will maintain low interest rates in most of 2010. So, in spite of the Dubai shock, the US dollar remained subdued over the week.

In fact, risk appetite began to return on Friday and equity markets in Europe recovered some of Thursday’s sharp losses. The greenback fell to a 14-year low versus the yen to finish the week down by 2.8%. The euro remained 0.7% higher on the week, while the pound weakened marginally.

The yen’s rise continued to provoke comments from Japanese officials about the one-sided nature of the Japanese currency’s move. Even the threat from the finance minister, Hirohisa Fujii, that disorderly currency movements would be met with “appropriate action” did little to halt the Yen’s march higher. It was up 2.1% over the week against the euro and 3.1% versus the pound.

The Vietnamese dong fell 2.6% against the dollar   over the week after the country’s central bank devalued the currency and lifted interest rates from 7% to 8% in an effort to narrow the gap between spot rates and black market rates.

In the local inter-bank market, the rupee gave up all its gains against the US dollar on Friday after heightened global risk aversion pulled down the local stock market. Month-end demand for dollars also weighed on the rupee.  Earlier in the week, the Indian unit had registered modest gains on the back of a weaker greenback overseas.

On Friday, however, it fell sharply and the pair traded in a wide range. Some dollar selling emerged as the rupee-dollar pair touched the level of 47.

Overall, during the week the pair traded in the range of 46.135-47.065 and the Indian unit finished the week marginally weaker against the US dollar.

This week, the key to gauging price action for the dollar will lie with the US market’s ultimate response to the Dubai crisis. So far, this event has not actually escalated to a crisis and we have not seen the market’s true response to the threat. The heightened volatility seen towards the end of last week was partly due to the fact that liquidity was thin due to the extended US holiday. When liquidity returns to the market, it will be easier to establish the correct trends as there will be a source for momentum. 

In Dubai’s proposal to delay repayment on its loans, the market is potentially faced with its largest sovereign default since the 2001-02 when Argentina halted payments on its own debts. Whether there is in fact a second round impact of this credit event remains to be seen. Both Standard & Poor’s and Moody’s have lowered their ratings on the nation’s sovereign rating but they have not yet deemed it a default.

Furthermore, the details on exposure are still not fully understood but considering the binding influence of risk appetite this year, a crisis for one region can rapidly spread across the globe.

The risk appetite has built up partly because there have been no tangible threats to economic and financial stability. This incident would remind market participants that conditions are far from robust and banking sector defaults or some other lingering danger can easily topple the markets. In contrast to the unpredictable nature of risk appetite, market participants will find it easier to deal with scheduled event risks.

This Friday’s US non-farm payrolls’ report represents the key event risk. Its status as a leading indicator for broader growth trends will influence Q4 US GDP forecasts as well as the timing for the monetary policy shift from the US Fed. The most volatile scenario for price action would come from a fall in the jobless rate and net increase in jobs — a sign that sustainable growth is much closer.

Among other data releases, the Fed’s Beige Book and ISM activity reports are important. The Fed’s economic report will give a sense of the data they are basing policy on, but it will not likely add much to the updated forecasts the minutes offered last week. The ISM services and manufacturing data are crucial from the perspective of overall employment, wage growth and consumer spending.

In the local market, the rupee would remain under downward pressure if the squeeze in risk appetite seen last week turns stronger.  From a macro-economic perspective, a debt crisis in Dubai has negative implications for capital inflows as well as remittance-related dollar inflows into India. The RBI would certainly try and curb any sharp volatility in the financial market, if global market events lead to it. The rupee-dollar pair can trade in the range of 46.25 -47.25 this week.

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