Rupee may consolidate after FII inflow-driven rally

Price action in the currency market last week was dominated by Asian currencies, especially the yen, followed by the rupee.

Both currencies were driven by the actions of their respective central banks. While the impact of the Japanese central bank action had a direct bearing on the yen, the actions of the Reserve Bank of India added to the bullish sentiment towards the rupee.

The yen fell over the week as the Bank of Japan (BoJ) intervened in the foreign exchange market after a gap of six years, to arrest the currency’s strength.

The rupee on the other hand rallied, helped by the RBI’s action of raising rates a little more aggressively than anticipated by the market. 

It appreciated 1.4% against the US dollar to close at a 3- month high over last week. A foreign portfolio inflows-driven 4% rally in the stock market provided the bullish backdrop for the rupee.

FIIs bought local stocks and bonds worth $2.2 billion over the week, thereby significantly stepping up their inflows into domestic markets.

The RBI’s action of raising reverse repo and repo rates by 50 bps and 25 bps respectively, along with an indication that monetary conditions are near normal and any further rate hikes will be data dependent, provided a positive boost to the stock market and the rupee.   

In the overseas market, the yen slumped from a 15-year high against the dollar last week due to the BoJ’s intervention in the currency markets.

It tumbled more than 3% against the greenback on Wednesday after hitting a high of 82.88 as Japan’s Ministry of Finance confirmed that it had intervened in the market, saying the Yen’s gains were “a problem that could not be overlooked”.

Market participants estimated that the Bank of Japan sold about 2,000 billion yen in an effort to rein in gains in the Japanese currency, which has been boosted by safe-haven demand amid ongoing worries over the health of the global economy in recent months.

The move caught the market by surprise since market participants had assumed that the victory of Naoto Kan, Japan’s prime minister, in a leadership contest on Tuesday made BoJ intervention less likely. 

Over the week, the yen fell 2% against the US dollar, lost 5% against the euro and dropped 3.9% against the pound.

Meanwhile, fears that the US Federal Reserve would announce a further round of quantitative easing in an attempt to stimulate the US economy undermined the US dollar against other major global currencies. 

The euro was the main beneficiary of the sliding greenback. There was some speculation that China was buying the single currency to engineer weakness in the US dollar ahead of a hearing in the US Congress this week called to examine the perceived undervaluation of the Renminbi.

Over the week, the greenback fell 2.9% to a one-month low against the euro, lost 1.8% against the Pound and dropped 1.5% against the Australian dollar. 

The US dollar’s losses were less acute against the Swiss franc. The greenback fell 1% after the Swiss National Bank (SNB) warned over the strength of its currency after its policy meeting on Thursday. Like the yen, the Swiss franc has benefited from safe-haven demand in recent months.

But it plunged after the SNB said it expected a marked slowdown in growth in the second half of the year and particularly in 2011, partly due to the currency’s strength. The Swiss franc fell 2.1% against the euro over the week.

This week, market participants will look forward to the US Fed’s rate setting committee meeting. Last week, speculation that the US central bank will increase its lending programme ushered the greenback lower.

The Fed will actually have this chance this week at the policy meet to initiate the second round of quantitative easing of monetary levers.

While the market consensus is not expecting the Fed to increase the size of its balance sheet any further, any such an outcome would undermine investor confidence and risk appetite.

Aside from this key event risk, market participants would closely follow the US factory and housing related data due through the week. These data points would provide evidence about the consumer confidence and the general level of economic activity.

The rupee remains a relative underperformer in Asia and that scenario may not change in significantly. Slower pace of capital inflows and rising merchandise trade deficit are now worrying the market participants about the external fundamentals driving the rupee.  

A widening merchandise trade deficit can seriously undermine the rupee.

Growing deficit puts further pressure on the current account and on the need for India to attract capital inflows to finance the gap and avoid pressure on the rupee. 

Trade deficit in August widened to a 23-month high of $13.1 billion, the highest monthly reading since September 2008 — when it had touched $15.4 billion. Rising non-oil imports and receding exports would only widen this gap, going forward.

Reflecting that concern, the commerce ministry estimates that trade deficit could touch $135 billion for the current fiscal, higher than the earlier forecast for $120 billion.

On the positive side, however, capital inflows are beginning to show some improvement, especially the FII inflows, which are supporting the stock market and the rupee.

However, they remain dependent on the pattern of global investors risk appetite. Any global event or weaker-than-expected data releases, particularly from the US can trigger risk aversion and negatively affect the portfolio inflows into India.

Another positive development for the rupee in the second half of the fiscal year comes from the current account inflows, especially NRI remittances. They tend to pick-up in the second half of the fiscal year.

After last week’s rally, the rupee-dollar pair could consolidate this week within the range of 45.50-46.25.

The author is senior economist, Royal Bank of Scotland NV. Views expressed herein are personal. E-mail: gaurav.kapur@rbs.com