Monetary tightening to help rupee

A new financial year starts this week and the latest round of monetary tightening by the Reserve Bank of India (RBI) has put in place enabling- conditions for the Indian rupee to strengthen.

On Friday, the RBI announced a hike in the repo rate by 0.25% to 7.75%. Along with that, the RBI also hiked the banks’ cash reserve ratio (CRR) by 0.5%, for the third time since December 2006.

Higher short-term lending rate and continued impounding of bank funds would be positive for the rupee. These measures would push up the interest rates in the economy and improve the relative yield advantage. The CRR hike, along with government’s borrowings, would ensure that any improvement in liquidity on the back of government spending in April, would be short-lived.

The banking system is thus likely to remain net borrower of funds from the RBI. That would exert upward pressure on the overnight call money rates and keep the carrying cost of US dollars for the banks high. Unwinding of banks’ long dollar positions on a sharp increase in carry costs has seen the Indian unit rise by 1.6% versus the greenback in the last fortnight. Even international price action is likely to be favourable for the rupee.

The greenback, which remains undermined by the concerns of a sharp slowdown in the US economy, got further hit last week on news of imposition of duty on imports of coated paper from China by the US government.

This step could invoke a retaliatory response from China and has heightened fears of a trade war between the two countries. The greenback is likely to suffer as a Chinese response could lead to lower US exports and higher inflation.

China could also hasten the process of diversifying its $1-trillion pile of foreign exchange reserves, from assets largely denominated in US dollar to assets in other major currencies.

Any agreement between the US and China over this issue would most likely involve faster appreciation of the Chinese yuan. That will be positive for all Asian currencies.

Under this backdrop, the rupee is likely to gain. However, RBI intervention, hardening crude oil prices and an equity market correction stand in the way of unabated rupee appreciation.

The RBI was on the sidelines in March, the last month of the previous financial year and its dollar purchases were much lower, compared to February. In the new financial year, however, the RBI would look to step up its market intervention, considering that the rupee is overvalued by about 7% (in trade weighted inflation adjusted terms) and the outlook for capital inflows is very positive.

Moreover, with the augmented market stabilisation scheme and the latest CRR hike, the RBI can easily sterilise the rupee liquidity injected in the process of buying greenbacks.

Tighter monetary policy could be negative for the Indian equities, as rising interest costs would put pressure on corporate earnings. That could induce a slowdown in foreign portfolio inflows into local equities. Upward pressue on international crude oil prices, with prices ruling well above $60 per barrel, after heightened geo-political pressures, would also pull the rupee down.

Considering these factors, the rupee-dollar rate is likely to hover in the range of 43.20-43.70 this week, with a bias for rupee appreciation.

Last week, an interplay of funds shortage induced sale of dollars by the banks. Dollar sales by exporters and demand for dollars by oil companies, along with short-covering by banks, saw the Indian unit trade in a wide range of 43.01 - 43.78.

The rupee rose to a seven-year high by Wednesday, but slid 1.7% from there on Thursday and closed the week with a 0.4% appreciation. That took the rupee’s appreciation versus the greenback in 2006-07 to 2.7%. In the international market, the US dollar underperformed the other major global currencies.

The greenback fell sharply on Friday after the US government said it would impose duties on imports of coated Chinese paper, reversing a policy of no duties on subsidised goods from non-market economies.

The greenback was already under pressure against the euro amidst signs of weakness in the US economy. Data released on Monday showed new US home sales fell to their lowest level in seven years, while weaker-than-expected consumer confidence and durable goods orders undermined the greenback.

The euro, on the other hand, was boosted by an unexpected rise in Germany’s IFO index of business sentiment and a larger-than-expected drop in German unemployment.

The Japanese yen saw heightened volatility over the week. After a 1% jump on Wednesday, following rumours of a military conflict between the US and Iran, the yen lost value over the next two days, as calm returned to markets. News of Japanese consumer price inflation slipping back to negative territory after 10 months added to the pressure on the yen.

http://www.dnaindia.com/report.asp?NewsID=1088250