Rising risk aversion could keep the rupee under pressure

Eurozone debt crisis is back in the forefront as warning about periphery country finances rises, Spain could be the next trouble spot.

Eurozone debt concerns reasserted a hold over the financial markets last week as the recent up move in US Treasury bond yields was halted and worries about Chinese policy tightening faded.

Further evidence of accelerating economic growth in the US and Germany bolstered optimism over the global recovery, although the US Federal Reserve maintained its extraordinary level of monetary support for the economy at its scheduled policy meeting. But it was the renewed uncertainty about the outlook for the eurozone periphery that provided the key price driver as market participants focused on rating agency actions and a summit of EU leaders in Brussels.

In the global currency market, the euro endured a volatile week against the US dollar as worries over the health of the eurozone and the performance of US Treasury yields dominated trading.
A drop in US Treasury yields at the start of the week sent the euro sharply higher against the greenback, only for the single currency to give back its gains as concerns over Spain’s public finances heightened.

Those worries were sparked by a warning on Wednesday from rating agency Moody’s that it might downgrade Spain’s debt.

A sharp five-notch downgrade for Ireland by Moody’s on Friday further soured sentiment towards the eurozone, while a warning from the IMF that Ireland faced significant risks that could affect its ability to repay an aid loan also hit investor confidence. An internal IMF report warned that Ireland would face “significant risks” in its ability to repay the Fund its portion of the 85 billion euro bailout package agreed late last month.

The euro received some support on Friday on news that European Union leaders had reached agreement on treaty changes to establish a permanent crisis mechanism to deal with eurozone debt problems. Over the week, the euro fell 0.4% against the US dollar.

The other European major, the pound, came under severe pressure last week as fears over the health of the UK economy resurfaced. Sterling’s fall came after a solid start to the month, fuelled by relatively robust UK economic data.

But last week, market participants questioned the building optimism surrounding the pound as figures showed UK unemployment and inflation were both rising, while consumer confidence was falling sharply.

Adding to the pressure on the Pound was a report from the Bank of England on Friday, which confirmed the central bank was concerned that the UK financial system was vulnerable to further turmoil in the eurozone. 

Over the week, the pound dropped 1.4% against the euro and fell 1.8% against the US dollar. It dropped more sharply against the Swiss franc, tumbling 2.8% to a record low over the week.

The Swiss franc also rose 1.4% to a new record high against the euro, as concerns rose over the debt problems of countries on the periphery of the eurozone. The Swiss franc rallied as market participants looking for exposure to Europe but wary of the single currency headed for the safety of the Swiss currency. Over the week, the Swiss franc climbed 0.9% against the US dollar.

Meanwhile, the greenback found support from indications that the US economic recovery remained on track. Notable among a string of data releases, US retail sales last month reached their highest level for three years. Housing and labour market figures were also broadly encouraging.

In the local market, the rupee slipped against the greenback over the week, as a stronger US dollar overseas and outflow of foreign portfolio capital exerted pressure on the rupee. Stock market gains lent some support to the rupee. The RBI’s decision to keep rates unchanged and inject liquidity in the banking system, helped boost market sentiment. Over the week the rupee-dollar pair traded in the range of 44.94-45.61 during the week.

Looking ahead, lingering sovereign debt risk fears in the eurozone — a driver for risk aversion — and a broadly supportive set of US economic data reinforce the likelihood of the greenback’s advance.

Indeed, the establishment of a permanent bailout fund in the eurozone for troubled member states is unlikely to calm markets considering the ratification process is unlikely to be completed anytime soon.

At the same time mounting stress in countries whose rescue is beyond the scope of existing European Financial Stability Facility (EFSF) — like Spain — is a clear and present near-term possibility. Meanwhile, US third-quarter GDP figures are set to be revised higher as home sales, durable goods orders and personal spending figures print broadly better in November.

In the local market, rupee can continue to remain on the back foot vis-a-vis the US dollar. High crude oil prices combined with a strong domestic demand driven push to non-oil imports, would remain a pressure point for the rupee.

Widening merchandise trade deficit has kept rupee under pressure so far this fiscal year, especially during times when capital inflows are choppy. FII inflows — the main source of capital inflow into India — have remained tepid in recent weeks and that could create volatility in the rupee-dollar pair. Global market environment also remains unsupportive for local stocks and therefore the rupee, given that concerns about the eurozone sovereign debt is back in the forefront. Overall the rupee-dollar pair can trade in the range of 45.20-45.75 during this week, with a depreciation bias.   

(The author is senior economist, Royal Bank of Scotland N V. Views expressed are personal. Email: gaurav.kapur@rbs.com )