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ShareRBI support through direct intervention and special market operations with oil companies would help contain the pressure
Almost one and half month after the last monetary policy meeting, the RBI decided to hike the repo rate by 0.25% to 8% on June 11. This rate hike came after a hiatus of 14 months and follows a 0.75% hike in the cash reserve ratio (CRR) since April.
With monetary conditions in the economy relatively easy, despite significant tightening over last couple of years and inflation threatening to touch double-digit levels, a rate hike was only a matter of time. In fact interest rates in the economy have moved up over last few weeks, anticipating some action by the RBI.
While this rate hike is favourable for the rupee, it need not provide much support in the near term. Even though nominal rates have risen, the level of real interest rates is very low. Moreover, with inflation rising throughout the emerging and the developed world, interest rates everywhere are moving northwards.
Thus, the interest differential advantage is negated to some extent. However, with WPI inflation likely to spiral past the 10% mark over the next few weeks, further monetary tightening by the RBI in the form of higher policy rates is likely. That should help the rupee over the next three to six months.
International currency price action would also prove negative for the rupee if it continues to be dominated by the strengthening of the US dollar. Last week, the greenback made its biggest weekly gain in more than three years.
A string of hawkish comments from US policymakers threw momentum behind the greenback, convincing market participants that the Fed rate-cutting cycle was over. In fact the interest rate futures markets are factoring in a rate hike before the end of 2008.
Ben Bernanke, chairman of the US Federal Reserve, said the danger of a "substantial downturn" in the US economy had receded over the past month but that inflation risks were increasing. A slew of similar comments from other Fed and US Treasury officials followed, with several emphasising on the need for the US dollar to strengthen to dampen inflation.
Besides this verbal support, two key pieces of economic data added weight to the idea that the Fed might start raising rates. Retail sales, a key indicator of consumption spending, went up twice as much as the forecast in May.
This suggests that the government's tax rebates are stimulating the US economy. Also, data on Friday showed that the US consumer price inflation jumped to 4.2 % in May.
The greenback's rally gathered pace through the week, as the market began to suspect the US would use the G8 meeting over the weekend to secure international support for the greenback. Currencies are not officially on the agenda for the meeting of finance ministers, which is set to focus on the inflationary threat of the commodity boom.
Over the past year, a high correlation has been observed between the greenback's slide and the doubling of the crude oil price. Therefore, a sustained appreciation of the US dollar will also help in easing crude oil prices.
The US dollar gained 2.3% against a basket of currencies, its biggest weekly jump since 2005. It added 3.1% against the yen, its best week against the Japanese currency for more than three years. It also gained 2.1% against the euro, more than reversing its losses in the week before last when the European Central Bank hinted at an increase in interest rates in July.
The Indian unit also depreciated by 0.7% against the US dollar last week after trading in the range of 42.77-42.94. Demand for dollars remained strong with FIIs pulling out another $790 million from Indian stocks and bonds. The RBI supported the rupee by selling dollars, thereby arresting a sharper slide.
The central bank, through its special market operations with oil companies, also ensured that their demand for dollars for meeting oil import bills was met by the RBI without putting pressure on the inter-bank market. The forward premiums rose sharply over the week, as interest rate differential between local and US rates widened on the back of a repo rate hike.
This week, international price action will be crucial for the rupee. If the US dollar strength persists, then the rupee and other Asian currencies would come under pressure. The US economic calendar is light with only moderate market-moving data due for release. These include producer prices, the current account, the Treasury International Capital report, housing starts, building permits and industrial production.
Meanwhile, there are a few Fed speeches that will most likely verbally confirm the central bank's hawkish monetary policy bias. Therefore, the US dollar can be expected to remain on a firm footing this week too.
Any turn in the greenback would help arrest the commodity price spiral, especially oil. That would be a positive move for the rupee, as that would help boost the overall investor sentiment on the economy and overall growth prospects. A downward correction in oil prices could prove helpful for equities, which in turn will be positive for the rupee. Thus, though dollar's strength tends to pull the rupee down, the indirect benefits of a stronger dollar could negate some of the pressure.
However, with the RBI's support, rupee's losses are likely to be limited. The rupee-dollar pair can trade in the range of 42.70 - 43.20 this week.
The author is senior economist, ABN Amro Bank. Views expressed here are
personal.
E-mail: gaurav.kapur@in.abnamro.com
