Eventful week to make rupee volatile

This week, global financial markets will closely follow what could be the most important euro zone event so far — yesterday’s re-elections in Greece and their outcome.

Opinion polls indicate another inconclusive result with the electorate divided between political parties supporting and opposing austerity measures.

It is believed that if the anti-bailout Syriza party wins, Greece’s exit from the euro zone would be inevitable. If New Democracy wins, there would be relief. The actual outcome and market reaction could well be more complicated than that. However, one thing is almost certain — markets are going to face extreme volatility.

The poll outcome could create several complex scenarios that could delay and exaggerate speculative movements across asset classes. Whether a new government could form quickly to implement bailout terms will hinge not only on election results but talks between political parties expected to begin today. Nevertheless, markets will react to either Syriza or New Democracy carrying a larger percentage of the vote.

In case markets interpret election results as a mandate for Greek exit, then two developments are likely: deterioration in credit health for other euro zone members with large losses in bond values; and sharp depreciation of the euro.

Panic-stricken investors will likely turn risk-averse, prompting major global central banks and policymakers to respond via a coordinated liquidity support for financial markets.

A no-exit scenario would buoy the euro and raise global risk appetite with a sharp rally in stocks and other risky assets. 
From that point onwards, market participants would quickly move their focus to determine whether the G20 and/or the US Federal Reserve will contribute to or hinder optimism. A G20 meeting scheduled for today and tomorrow could open up global funding.

The Fed will hold its monetary policy meeting on Wednesday. Any sign of another round of monetary stimulus would exert downward pressure on the US dollar.

The vote and likely additional stimulus efforts could distract markets in the short term, but would do little to solve the underlying euro zone issues.

In India, the RBI, as part of its monetary policy review today, is likely to announce another round of stimulus to support flagging growth momentum. The market is expecting only a repo rate cut of 25 bps. This may prove to be a damp squib unless there is a reduction in the bank’s cash reserve ratio (CRR) too, without which markets and the rupee are unlikely to gain significantly.

In case the RBI cuts both the repo rate and the CRR, rupee and stock markets will bounce. A CRR cut will also bolster the RBI’s ability to sell dollars to support the rupee, without adding to the strain on the rupee liquidity conditions in the banking system.

However, global events are likely to dominate the local price action. In case of severe deterioration in the global investor risk appetite, the most likely immediate impact would be a sharp depreciation of the rupee and a steep fall in the equities. Other asset classes would also come under a lot of strain.

Dollar shortage in the inter-bank market could become severe as there would be a flight of capital and inter-banking funding markets could freeze for some time, like during the Lehman crisis, the previous most severe market dislocation in 2008. Rupee liquidity would also be squeezed as the RBI would have to intervene aggressively and sell dollars to stem the pressure on the rupee.

Moreover, the economic impact on India of the euro zone troubles would be particularly severe at a time when growth is already slowing. Export demand would shrink as external demand has a close correlation to world trade growth. Global trade contraction is highly likely in the event of synchronised recession in major global economies. Investment cycle in India would be hampered severely and even domestic consumption would be adversely impacted on account of a loss of confidence.

This week, therefore, will prove very crucial in deciding the near-term price trend in the global currency markets.

The writer is senior economist, Royal Bank of Scotland N.V. Views are personal.  He can be contacted at gaurav.kapur@rbs.com