Equity market recovery will help rupee gain ground

The sentiment of fear prevailed in the markets last week and aversion towards risk intensified. Investors across the world scrambled for the safety of bonds and cash as they liquidated their risky carry trades positions. Among riskier assets being offloaded, they chose equities in particular, leading to a sharp sell-off in equity markets across the globe.

Currency markets reflected this mood of risk aversion. The Japanese yen, which has been the mainstay for funding carry trades, registered its biggest weekly gains against the US dollar since 1998. It rose by 3.4% over the week.

The greenback itself benefited from this flight to safety, as investors lapped up US Treasury securities. High yielding currencies like the Australian and New Zealand dollars and the European majors tumbled sharply.

Over the week, the US dollar jumped 6.8% against the Australian dollar and 8.3% against the New Zealand dollar. And, the euro and pound depreciated by 1.6% and 2.1%, respectively, against the greenback. Emerging markets currencies also took a hit as nervousness spread across the globe.

The local stock market also saw a large pull-out by foreign institutional investors (FIIs). They sold Indian assets worth $1.1 billion last week, taking their total net sales to $1.4 billion in the month of August. This led to a 5% decline in the Sensex over the week and that in turn saw the Indian rupee lose 1.7% versus the US dollar.

The rupee suffered most of its losses on Wednesday as the BSE-Sensex tripped by 642 points. Moreover, influenced by the heightened volatility in the equity market, the rupee-dollar pair traded in a very wide range of 40.52 - 41.70.

On Friday, the US Federal Reserve (Fed) provided some relief to the market. The Fed reduced its discount rate - the rate at which banks can borrow from the Fed against a wide range of collateral, including subprime mortgages - by 50 bps.

The discount rate is now 5.75%. The discount rate cut could lower the cost of capital for banks and help keep credit flowing through the economy at a time when investors have shown a greater reluctance to lend.

Explaining this move, the US central bank said the financial market conditions had deteriorated to the point where “the downside risks to growth have increased appreciably”.

It added that it was monitoring the situation and was “prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets”.

This surprise and rare inter-meeting move by the Fed has also increased the chances of a cut in its monetary policy rate — the Fed funds rate. It is the US central bank’s target rate for the overnight rates in the banking system.

Fed funds futures already indicate that investors expect several quarter percentage point cuts from the current 5.25% by the end of the year. The Fed discount rate could also prompt other key central banks in the Euro-zone, UK and Japan, to delay their rate hikes.

This Fed action to contain the fallout of the financial market turmoil on the real economy would infuse some confidence among investors. Their extreme sense of caution towards risky assets could give way to some optimism. That was evident in the US equity markets which rallied on the rate-cut news.

This would have a positive spill-over effect on Asian equity markets when they open on Monday. The Indian stock market is also likely to gain, which would be positive for the rupee. Weakness in the greenback, following a discount rate cut and on the back of the rising probability of a Fed funds rate cut, will also help the rupee.

While the volatile capital flows from portfolio investments of FIIs are crucial in determining the strength of the rupee in the short term, its long-term direction is dependent upon the stable capital inflows from the foreign direct investment (FDI) route. And, India’s attractiveness as a long-term investment destination remains in tact.

The latest FDI data released last week reiterated that. FDI into India almost trebled to $4.9 billion during the June 2007 quarter from a year earlier. During January-June 2007, FDI inflows were $11.4 billion, more than three times the $3.6 billion received a year earlier.

This data is also likely to boost the market sentiment, especially at a time when the outlook for capital inflows into India does not look as bright as it did before the restrictive guidelines on the external commercial borrowings were put in place.
This week therefore, the rupee is likely to recover some of the value it lost to the greenback last week.

The equity market movements would continue to drive the action in the rupee-dollar pair. However with caution still prevailing among markets participants, the equity market and therefore the rupee could continue to witness volatile movements. The rupee-dollar pair could thus trade in the range of 40.75 - 41.25.

The author is senior economist, ABN Amro Bank. Views expressed herein are personal.
gaurav.kapur@ in.abnamro.com