Capital inflow scenario favours Re

This week market attention will be on the all important US inflation reports. Both producer and consumer price inflation data for October is due for release this week. Core consumer price inflation (excluding food and energy) is expected to be higher compared to the previous month. That would support the greenback, as rising inflation would mean that the US Federal Reserve would hold rates unchanged in the near term. Other important US data include the Treasury report on capital inflows. Among the important non-US data releases Euro-zone and Japan third quarter GDP data will be closely watched.

With the RBI showing its intentions to intervene in the local currency market, market participants would be cautious in selling the greenback. Otherwise capital inflow scenario remains favourable for the rupee. An equity market slide and a pull-out by the FIIs remain the key risk points. The rupee-dollar rate is likely to hover in the 44.50 - 44.85 band this week.

Central bankers’ talks dominated the currency market action last week. Most of their critical jawboning centered on the issue of diversification of central bank foreign exchange reserves. 

The US dollar was sent tumbling on Thursday, after the People’s Bank of China (PBOC) governor Zhou said at a conference in Europe that the PBOC has a “clear diversification plan” drawn up for the next few years which is centered around moving away from US dollar denominated assets.

China holds the world’s largest stock of foreign exchange reserves, which crossed $ 1,000 billion last week. An estimated 72% of this horde is parked in US dollar assets and with the greenback poised for a decline over the medium term these assets will erode in value.

Zhou went on to stress that the diversification would be a gradual process as ‘dumping’ dollars would stress the US economy, one of China’s largest trade partners and
cause large losses on their own books. A substantial selling of greenback by the PBOC would send it down sharply. In recent months, central banks in the Middle East and Europe have also considered reallocation of the US dollar portion of their reserves to non dollar assets.

Earlier on Monday, San Francisco Federal Reserve President Janet Yellen had also noted that some countries with excess savings may consider investing less of their funds into US dollar-denominated assets at some point.

The greenback slipped across the board as the talks of Chinese reserve diversification gave market the reason to sell it, in a week which was otherwise light in terms of economic data releases.

The Euro emerged as the favorite currency of the market last week and rose to a ten-week high against the greenback, a one-year high against the Pound Sterling and to a new all-time high against the Japanese Yen.

The Pound gained against the greenback but finished lower against the Euro, as after hiking its target benchmark rate by 0.25% to 5%, the Bank of England (BOE) sounded neutral on the future course of monetary tightening. The BOE stated that consumer price inflation is likely to abate in the near future. That would reduce the need for more rate hikes.

The Yen got some support from the Bank of Japan (BOJ) Governor Fukui’s relatively hawkish statements last week. Fukui reiterated the BoJ’s stance for gradual and watchful tightening of monetary policy.

Additionally, he downplayed the impact of further rate hikes, saying they would neither result in a strong tightening nor be aimed at derailing the economic recovery.

In line with the recent official Japanese concern for Yen funded carry trades, Fukui also raised the issue of carry-trade activity and expressed his wariness over the possibility of strong unwinding of Yen carry trades. He noted that the BoJ staff was trying to assess the size of current Yen carry trades. A rapid unwinding of these will see the Yen appreciating sharply, which is not desirable considering that it, could hurt Japanese exports.

In the local inter-bank market, the RBI finally stepped in to curb the rupee’s upward climb against the US dollar last week. The central bank bought dollars aggressively through state-run banks on Friday, after the rupee touched an 8-month of 44.35 against the greenback. That ensured that the rupee closed the week at 44.68 per USD, only 0.3% stronger over the previous week’s close. RBI intervention also helped to inject rupee liquidity into the banking system.

Earlier last week, the rupee rose sharply after slipping to 44.90 on Monday. Exporters and foreign investors kept up the supply of dollars. The banks also sold dollars, noting greenback’s weakness overseas. On the demand side, oil importers bought dollars. The rupee-dollar rate hovered in a wide band of 44.35 - 44.93 last week. The Indian unit has appreciated by about 0.7% in the first two weeks of November, adding to its cumulative gains of 3.3% over the months of September and October.

(The author is Senior Economist, ABN AMRO Bank. Views expressed herein are personal. E-mail: gaurav.kapur@in.abnamro.com)