Brace for greater volatility in the rupee-dollar pair

The year-end rally in risk assets halted as financial markets moved into holiday mode last week. However, the underlying mood of bullishness over the global growth outlook remained largely intact. Stock markets in the United States (US) and Europe hovered near their best levels since before the collapse of Lehman Brothers in September 2008 and crude oil traded at a two-year high. At the same time concerns about Euro-zone sovereign debt weighed on the market sentiment, driving the euro to a three-week low against the US dollar. On Thursday, rating agency Fitch announced it had cut Portugal’s debt rating.

In the currency markets, the Euro fell in the wake of a sovereign debt downgrade for Portugal by Fitch. Portugal’s long-term and local currency ratings were lowered by one notch to A-plus late on Thursday by Fitch, taking its rating to the same held by Moody’s, but two notches above the A-minus held by Standard and Poor’s.

Fitch added that it was keeping a negative outlook on Portugal, saying it expected the country’s economy to return to recession in 2011.

The Euro depreciated by 0.5% against the US dollar and by 0.1% versus the Pound. The single currency fell against the Swiss franc, losing 1.3%.

The Swiss franc has been the best performing big currency this month as fears over the fiscal health of countries on the periphery of the Euro-zone have fed haven demand. The US dollar, which has also seen a record low against the Swissie in recent sessions, fell 0.8% over the week.

The other European major, Sterling rallied from its three-month low against the US dollar, but stood lower by 0.6% over the week. Against the Yen, the Pound was down by 1.9%. The Yen was up 1.3% versus the greenback.

The Australian dollar continued to move higher, having broken parity with its US counterpart for the first time in six weeks on Wednesday. The Aussie has benefited as commodity prices pushed higher into the end of the year and demand for the risk-sensitive currency was bolstered as global stock markets rose to their highest level since the collapse of Lehman Brothers.

The Australian dollar added 1.5% against the greenback.
In the local market, rupee appreciated against the US dollar as local stock market rallied and exporters sold dollars. However, some corporate dollar demand checked rupee’s rise. Over the week, stock market rallied by over 1%, while portfolio inflows remained tepid.  Market activity was thin and the rupee-dollar pair traded in the range of 44.97 - 45.66 over the week and finished the week with 0.5% gains over the week.

The outlook in the global currency markets for this week is anchored to the extended holiday weekend, which will lead to thin liquidity. Yet there is a lingering risk of volatility.

In the past month, the threat to global economic activity and financial market health has perceptibly deteriorated. In Europe, the long-term implications of excessive dependence on stimulus and lack of access to the markets for capital threatens to push some members countries into interim recessions while others seem to see little way out aside from a debt restructuring. In China, the threat of an asset bubble has grown quite real with the government moving to drain liquidity from the system - but ultimately failing to curb the extreme levels of leverage already built into the system. The instances of economic and financial imbalance along with an overdependence on temporary government stimulus are wide-spread.

And yet, through it all, the equity markets in the US and Europe have climbed consistently since the beginning of September to levels last seen before the Lehman Brothers collapse. It is difficult to reconcile a lack of participation in this advance in risky assets with the steady advance in equity benchmarks. Capital infusions by central banks and governments are clearly going directly into the capital markets rather than the more fundamental areas of the economy and this misallocation may soon be reconciled. Such a correction may play out next month in a new trading year.

In the local market too, activity could be slow this week on account of the year-end holidays. However, the rupee is entering 2011 on a weak note. Rising commodity prices, especially crude oil is likely to put pressure on the already ballooning merchandise trade deficit. Last week, crude oil closed above $90 per barrel. Support from portfolio capital inflows has been patchy. However, with stake sale in IOC and ONGC lined up in the first quarter of 2011, rupee is likely to receive support from a pick-up in foreign institutional investor (FII) inflows. The IOC equity sale will be bigger than that of the Coal India, which was the biggest IPO of the country.

Other than that, stock market could remain range bound. Relatively better growth fundamental and resultant improvement in corporate revenue and profitability are largely priced in. However, persistent and high inflation can drive up interest rates into 2011, which could affect overall economic activity and that may lead to some correction in the stock markets. Even constant supply of equities may dampen the interest of global investors. That combined with the fact that capital inflows into India are dominated by FII inflows can make rupee-dollar pair prone to sharp volatility.

Capital inflows from other sources, especially foreign direct investment and external commercial borrowings, which are more durable in nature, are crucial in supporting sustained appreciation of the rupee. These flows however, remain tepid compared to portfolio inflows.

Overall while current account deficit can be bigger is the next fiscal year, capital inflows may not significantly pick-up, especially inflows which are more stable in comparison to hot money flows from FIIs. Hence, rupee-dollar pair may continue to trade in the wide range of 44.00 - 47.00 in 2011. The pair may see sharp movements within this range though, especially during periods where capital inflows are bunched up. The US dollar’s position overseas may also remain strong and that too would put pressure on the rupee periodically.

The writer is senior economist, Royal Bank of Scotland NV, and can be reached at gaurav.kapur@rbs.com. Views are personal.