Divergent monetary policies positive for India

Inflows from Europe, falling crude oil to come to the rescue if rupee cracks against the dollar

Two central banks in the developed markets are walking in opposite directions in monetary policies. While the US is ready to tighten rates, the European Central Bank last week announced a further cut in rates and a stimulus programme.

India is expected to gain from any stimulus programme, as it would result in higher capital flows. Not surprisingly, the rupee has held on against the dollar even as most developed market currencies have capitulated against it over the past couple of months. During the same period, the Dollar Index has moved up five per cent, while the euro has fallen below 1.30 against the US greenback.

Both these developments are expected to impact India. Equity strategists and derivative experts claim India's implied volatility is at its lowest, as the market expects no knee-jerk reaction from the US Federal Reserve. According to Nomura, a stronger dollar, driven by expectations of divergent monetary policies of the Fed and other major developed world central banks, is positive for Indian equities. The brokerage feel broad dollar strength typically begins six to nine months ahead of a rate tightening cycle, a phase just beginning. The implication is that a rate tightening is likely only in 2015.

Interestingly, a strong dollar would put pressure on the domestic currency, though emerging market currencies have fared better so far than the developed markets' currencies. The rupee has held on well against the dollar, as capital flows have remained strong. Divergent monetary policy moves by two central banks will have an impact on the rupee undoubtedly. Indranil Sen Gupta of Bank of America Merrill Lynch says the stronger the dollar pressures and the Reserve Bank of India (RBI) will continue to hold the rupee in a 58-62 per dollar range, if the dollar settles around 1.30 a euro with oil prices softening and gold import curbs holding the current account deficit at 1.7 per cent of gross domestic product.

While falling crude prices come to the rescue of a weakening rupee (which makes imports more expensive), Dhananjay Sinha of Emkay Global believes the divergent monetary policies of the US and ECB could eventually test the resilience of emerging market currencies. If this happens, RBI will continue to purchase dollars to keep import cover at 8-10 months. For now, things don't look too bad for India.