Strong equity markets, right RBI moves can help rupee

Rate cuts and liquidity infusion can help equities and the Indian unit

Central banks around the world eased the monetary levers further last week, as signs of a recession and global economic slowdown became imminent.

The third quarter US GDP shrunk by 0.3%, as personal consumption plummeted by 3.1%. This is the clearest evidence that the US economy has entered a recessionary phase.

Led by the US Federal Reserve’s 0.5% rate cut, the Bank of Japan followed with a 0.2% cut. Emerging market central banks in China, South Korea, Taiwan, Hong Kong also reduced policy rates. With inflationary pressures having subsided significantly and the growth outlook having worsened, central banks are choosing to be cautious.

Investors and other market participants were bolstered by these moves and became less risk-averse. Price action in the currency markets reflected that both the US dollar and the Japanese yen weakened against other major currencies last week.

Emerging market equities gained and currencies benefited from this backdrop, repairing some of the damage done in October. Foreign exchange markets experienced extreme volatility in October as recession-wary investors continued to shy away from risk and parked cash in the relative safety of the yen and the greenback.

In India, the Reserve Bank of India also announced measures to ease liquidity and monetary conditions. It not only announced another 0.5% cut in the repo rate, but also eased cash reserve ratio (CRR) further by 1% and reduced the statutory liquidity ratio (SLR) by 1%.

These steps, along with other liquidity infusion measures such as the buyback of market stabilisation bonds, are aimed at ensuring adequate rupee liquidity in the banking system.
Liquidity was again under strain last week and call money rates spiralled back towards 20%, due to massive dollar selling by the RBI. In October so far, the central bank’s forex reserves have fallen by $25.5 billion, as it has had to aggressively intervene in the currency market to curb rupee depreciation.

The recent moves will bolster the RBI’s ability to sell dollars and support the rupee without putting undue pressure on liquidity. This unprecedented move by the RBI is likely to the boost the local stock market too, which in turn will prove useful for the rupee. However, the currency is also losing its relative yield advantage, which could prove to be a negative in the medium term.

This week, the rupee can get some support from a likely bounce in the equity market.  Even otherwise, the RBI will continue its intervention to support the rupee. Last week, the rupee appreciated by 1% against the greenback, helped by a 12.5% jump in the sensex and some weakness in the US dollar.

FIIs, however, remained net sellers of local stocks and bonds and withdrew $870.2 million of funds last week, taking their total net sales to $4.3 billion in October. The rupee-dollar pair traded in the range of 49.23-50.28 in a holiday-shortened week.

Last week drew to a close a particularly volatile month for major currencies too. The euro had its worst monthly decline against the US dollar. The pound fell to a record low against the euro. Reversal of carry trades saw rapid appreciation of the yen, raising the prospects of intervention in the currency market by central banks. De-leveraging gained pace throughout the month of October.

Investors dumped stocks, commodities and corporate bonds. This pushed the greenback higher, as investors repatriated their cash into the US treasury market while the yen found itself the target of funds looking for safety in its low yield and current account surplus. The US dollar also had help from the Fed, which continued to proactively avert a severe recession.

The pound fell 9.9% against the US dollar, its worst monthly fall since October 1992, the month after the pound’s expulsion from the exchange rate mechanism. Last week though, the pound rose by 3.7%.

The euro, meanwhile, was down 9.7%, its biggest monthly decline. It, too, rallied last week, up 0.8% on the week. Gains for the Japanese yen were even more spectacular despite its losses last week. During October, the yen climbed more than 16.2% against the euro and 16.3% versus the pound. It also rose 7.2% against the greenback.

Market focus this week will again be on the US economy as a slew of important data releases are due. The ISM manufacturing and services indexes are forecasted to reflect a contraction in business activity during October. The US non-farm payrolls are anticipated to contract for the 10th consecutive month by 1,80,000 while the unemployment rate is expected to jump to a more than 5-year high of 6.3% from 6.1%.
Overall, the US Fed remains likely to cut rates down to record lows before year-end, as indicated by Fed Fund futures which are fully pricing in a 0.25% cut on December 16 and a 55% chance of a 0.5% cut.

Nevertheless, if economic data from other regions such as the UK and Euro-zone prove to be more bearish, the US dollar could gain on safe-haven flow. This week, both the European Central Bank and the Bank of England could also cut rates.

In the local market, the rupee could hold onto its gains from the previous week if equity markets remain buoyant. While the RBI action is sufficient to fuel some bounce, a global equity market rally is a necessary condition to sustain that bounce. That, in turn, depends on investors’ appetite for risk. Overall, the rupee-dollar pair can trade in the range of 49.00-49.70 this week

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