Oil prices remain the key to rupee buoyancy

Credit market related problems could keep investors cautious

After a week full of crucial events, the landscape in the currency markets was broadly unchanged. In continuation of its recent weakness, the US dollar plunged to new lows, as the Federal Reserve cut the overnight fed fund rates by 0.25%. And, while the Fed moved to a neutral stance, concerns about the financial sector’s exposure to credit market losses saw futures markets price in another Fed rate cut in December.

At home, the RBI surprised the market to some extent, by raising the cash reserve ratio (CRR) by 0.5%, while keeping the policy rates unchanged. Citing strong inflationary pressures and excess liquidity, the RBI tightened the monetary levers further. On one hand, this move is positive for the rupee, given that it helps to improve the yield advantage.

On the other hand, a higher CRR enables the RBI to buy dollars while keeping a check on the level of free liquidity in the banking system. Therefore, while local assets become more attractive to foreigners, the RBI can step-up its intervention to curb rupee’s gains.

Over the week, the rupee appreciated by 0.3% against the greenback. Bullish sentiment towards the Indian unit was also reinforced by weak US dollar overseas, besides the RBI move. Foreign Institutional Investors (FIIs) also turned net buyers of Indian assets last week, after having shunned them in the week before last. Their purchases amounted to $195.3 million.

The rupee did come under some pressure on Thursday and Friday, as the local equities fell on cues from the global sell-off in equities. Otherwise, the RBI continued to put brakes on the pace of rupee appreciation. Overall the rupee-dollar pair traded in a range of 39.18 - 39.485 during the week.

In the international market, the US dollar saw new lows last week as a rate cut by the Fed took away more yield support from the beleaguered currency. The Fed indicated a neutral monetary policy bias in its statement, saying it judged that the “upside risks to inflation roughly balance the downside risks to growth”. The US central bank also stated that “strains in financial markets have eased somewhat on balance”.

However, the Fed stance was questioned after the sudden burst of risk aversion on Thursday amid fears that large financial institutions had not revealed the true scale of losses related to the crisis in the US subprime mortgage market. This turmoil helped the market lift the probability of a rate cut at the Fed’s December 11 meeting to about 70%.

Better-than expected US non-farm payrolls data for October also provided only momentary support to the greenback, as it stoked risk appetites among investors. Even otherwise, the details of the jobs data, which showed that job creation in the manufacturing sector remained weak, added to the growing evidence of slowing pace of activity in the sector. Robust third quarter US GDP growth of 3.9% was also ignored by the market, discounting it as historical information.

The Pound Sterling outperformed its major currency peers last week, as hawkish comments from the members of the Bank of England’s monetary policy committee tempered hopes of any rate cuts in the near future.

This week, the appreciation pressures on the rupee would persist. Tight monetary policy stance along with robust growth potential, continue to provide a favourable environment for capital inflows to remain strong. Further evidence of the underlying growth momentum in the economy was provided by the ABN Amro India Manufacturing PMI data (equivalent of the US ISM index) last week.

The October reading of headline PMI at 61.7 was the highest in the 31-month history of the index. All the key production related sub-components of the PMI — output, new orders and new export orders also registered their strongest readings to date. Notably, even the level of foreign business grew despite a stronger rupee.

Even international price action is likely to be supportive of a stronger rupee, as the greenback is expected to loose more ground against the high-yielding currencies.

However global crude oil’s climb towards $100 per barrel continues unabated, with WTI crude price rising by 4.4% last week to close at $96. The cost of India’s imported crude oil basket had also risen to about $88 per barrel by the end of last week. The average price of this basket so far this fiscal year has been $71 compared to $62.5 for the whole of last fiscal year. Rising crude oil prices remains one of the main threats to unabated rupee appreciation.

The other risk which can play out in the near-term is the risk of a slowdown of portfolio inflows and resultant equity market volatility. With credit market related troubles for the financial sector still in the process of manifesting, some more episodes of risk aversion cannot be ruled out. Caution among global investors would lead to a slowdown of funds to riskier asset classes.  Market participants would therefore remain vigilant of last week’s negative news flow extending into this week. Overall the rupee-dollar pair is likely to trade in the range of 39.15 - 39.55 this week.

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