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ShareCautiousness among FIIs and investor risk aversion bode ill
Financial markets across the globe spent another week reeling in turmoil. Bad news from the US financial sector and growing fears of recession in the US and an overall slowdown in the world economy kept market participants looking for safety last week. Equities, in particular, were on the receiving end of this mood of risk aversion among investors. Stock markets in the developed countries and even emerging markets registered heavy losses.
In this backdrop, currencies with high-yield support like the New Zealand dollar lost ground to low-yielding currencies like the Japanese yen, as carry trades were unwound. Among the major currencies, the European majors came under pressure, as data pointed towards lower interest rates in the euro zone and the UK, going forward. The euro underperformed its peers. The US dollar also remained on weak ground, as economic data gave more signals of the US economy slipping into a recession.
Pressure remained on high-yielding currencies last week, as two of the biggest US investment banks reported large losses related to their exposure to subprime mortgages. Bond insurance companies were also threatened with ratings downgrades. This deepened investor concerns about the credit market crisis and its negative impact on the economic activity.
The yen climbed strongly, as investors unwound their carry trade positions further. The yen carry trade - where borrowings in yen are used to purchase riskier, high-yielding assets - was popular in the first half of 2007, as booming equity markets ensured healthy appetite for risk.
But the deepening of financial market troubles that began in August last year has seen carry trades scaled back. And, since the beginning of this year the yen has been climbing, as investors look for safe havens amid the turbulence in equity markets.
One of the main beneficiaries of these carry trades, the NZ dollar, was down 4.9% against the yen last week. The yen also climbed 2% against the greenback, gained 3.2% versus the euro and was up 3.4% against the Australian dollar.
Meanwhile the price action in other major currencies continued to be driven by expectations about the extent of interest rate cuts. The pound sterling fell on Friday after soft retail sales data added to the likelihood of a rate cut at the next monetary policy meeting of the Bank of England. The BOE will meet in February. December retail sales fell 0.4% over the previous month, against an expected 0.2% rise. Year-on-year sales growth was down to 2.7%, the lowest since September 2006.
These numbers seemed to suggest that consumer spending in the UK is buckling under the combined pressure of rising food and energy bills, increasing credit costs, flat wages and negative wealth effects from the housing and equity markets.
The pound fell 0.9% against the greenback on Friday, and was 0.5% weaker against the euro. Over the week, however, sterling was stronger against the euro.
The euro was undermined by indications that the European Central Bank was set to ease its hawkish stance on interest rates. Data showed tightening credit conditions for businesses and homebuyers, which would in turn impact economic activity. Over the week, the euro fell 1.1% against the pound and was also 1.2% weaker against
the dollar.
In the local inter-bank market, the rupee continued to trade in a narrow band against the dollar. The RBI thwarted appreciation pressures arosing from capital inflows for equity offerings.
Meanwhile, the weakness in the stock market had a marginal impact on the rupee. The BSE Sensex fell by 8.8% over last week, but market participants remained bullish about the rupee. The offshore forwards market, however, was betting on a weaker rupee in the near-term and that had some impact on the onshore market too, as some market participants bought dollars to take advantage of this arbitrage. The rupee-dollar pair traded in a range of 39.24 - 39.35 over the week and the rupee finished the week almost unchanged.
This week, the rupee could face some downward pressure on account of the weakness in the stock market. With gloom persisting among investors globally, equities would remain out of favour. In case of India too, the FIIs could be turning cautious. Last week they were net sellers of local stocks and bonds and their sales amounted to $951 million. This seems to suggest that they could be booking profit in the secondary market and using those funds to invest in the IPOs, instead of committing fresh funds to India.
The RBI also seems determined to keep the rupee from appreciating any further for the time being and can therefore be expected to continue intervening in the market. Last week, the prime minister's economic advisory council endorsed sterilised intervention by the RBI in order to slow down the pace of the rupee appreciation in the medium-term. The council, however also pointed out that expectations in the economy should be geared towards greater exchange rate flexibility.
Otherwise, declining oil prices could offer some respite from the trade side pressure on the rupee.
Overall, the rupee-dollar pair could trade in 39.20 - 39.50 range with bias towards a weaker rupee.
The author is senior economist, ABN Amro Bank. Views expressed herein are personal.
E-mail: gaurav.kapur@in.abnamro.com
