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Abheek Barua & Shivom Chakravarti: The rupee: shifting sands

Concerns about India's domestic problems have added to the pressure from global factors

Abheek Barua & Shivom Chakravarti 

The rupee is back under pressure as the cumulative effect of foreign investors’ disappointment over the Budget and adverse global news has begun to bite. The Reserve Bank of India (RBI) has remained somewhat on the sidelines in March but going forward could supply dollars more aggressively. However, it is unlikely that the rupee will slip back below 50 to the dollar soon. The central bank’s intervention could cap the rupee at a level of, say, 52 to 52.50 and a new trading range of 50-52.50 could emerge for the current quarter.

The negative sentiment towards India in the wake of the Budget is not just on account of the General Anti-Avoidance Rules (GAAR) that could result both in taxes being imposed on transactions done in the past and draw new investment instruments into the tax net. There are more “fundamental” doubts about the finance minister’s ability to meet his fiscal targets and what an overshoot could mean for interest rates and inflation. There is considerable scepticism about his ability to keep subsidies below the two per cent of GDP cap that he has announced. The fracas over the Railway Budget certainly hasn’t helped in enhancing the government’s credibility and only concrete action in the form of, say, a diesel price increase would convince the markets that the government means business.

The global situation remains just as murky as it was last month when the market was getting panic attacks over the possibility of a Greek default. Greece’s problems may have been sorted out at least temporarily but that has been replaced quickly by growing concerns about Portugal and Spain’s fiscal positions. An increase in the size of the continent’s bailout mechanism could provide temporary relief but lingering doubts about its adequacy will remain. Apart from these “structural” issues about the solvency of states on euro zone’s periphery, there are worries about how sharp the cyclical downturn in the region can be. The Purchase Manager’s Index for manufacturing in Germany came in at 48.1 for March (anything below 50 represents contraction in activity) and renewed fears that Europe might not just get away with a shallow recession. If growth deteriorates sharply, the risk of fiscal slippage will increase and this in turn will push sovereign yields up. The vicious cycle of higher yields, rising interest costs and widening deficits could return with a bang.

China’s dimming growth prospects have added to the list of woes. The government has projected a growth rate of 7.5 per cent for 2012. That in China’s context constitutes a fairly major slowdown. Government forecasts in China have historically been conservative. However, even if one factors that in, GDP growth of over eight per cent seems unlikely in 2012. Besides, China still has an overheated housing market that combines sky-high prices with a visible oversupply of housing stock. Thus, the risk of an implosion in the housing market remains and were that to happen China could see a considerably lower growth than is factored in by most forecasters.

The rise in global uncertainty has bred a “risk-off” sentiment in the global markets and groups that are seen as risky have sold off. As a consequence, Indian stocks indices and the rupee have come under pressure. Concerns about India’s domestic problems have added to the pressure from global factors. This has meant that while over the past month, all emerging market assets have seen selling pressure, both the Sensex and the rupee have fared worse. This is in contrast to January when India clearly “outperformed” other markets.

Despite the current gloom, we are somewhat upbeat about the rupee’s medium-term prospects. For one thing, the “bad news” about India is getting rapidly priced into Indian assets and the currency. It is possible that over the next three months, the financial markets factor in all possible “negatives” about India. As that happens, even small bits of positive news could drive a market rally in stocks and currencies. If indeed, the RBI starts paring interest rates from April, it could set a bottom to the domestic growth cycle. Thus, if we start seeing better macro numbers from the second half, the markets could start riding on this data.

There are three other factors that give us some comforts. First, if the Chinese economy does wobble, it is likely to drive commodity prices lower since it is seen as a big guzzler of commodities. If commodity prices soften, India will be among the emerging markets to gain the most since it is a heavy importer of commodities. Second, Fed Chairman Ben Bernanke has reaffirmed his commitment to keep interest rates on hold at least until 2014. He still seems open to the use of unconventional monetary instruments to battle unemployment. Thus, another round of liquidity infusion from the US through some variant of “quantitative easing” is possible. Third, Europe’s lingering problems warrants more monetary stimulus from its central bank, the European Central Bank (ECB). The new ECB president, Mario Draghi, clearly does not share his predecessor Jean Trichet’s inhibitions about using liquidity to counter Europe’s sovereign debt problems. Another round of liquidity infusion from the ECB in the form of another bank refinancing programme or a traditional asset purchases programme seems plausible by mid-2012. This liquidity infusion could benefit emerging market assets and currencies, including the rupee.


The authors are with HDFC Bank. These views are personal

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First Published: Mon, April 02 2012. 00:46 IST