Rupee's ascent

After the selloff in the equity market around May, foreign portfolio inflows had started dwindling and the rupee started to depreciate. Rising oil prices further accentuated that trend.

Yet, despite a higher level of inflation and slow movement on domestic interest rate increases, the rupee has started appreciating against the dollar once again.

A closer look shows a common pattern running across all floating Asian currencies. All of them had depreciated against the dollar since May, and all of them have started appreciating in recent weeks. This suggests that the reason for the change in trend has to be found in global, rather than local, factors.

Another clue to the riddle lies in the behaviour of stockmarkets throughout Asia. After the nosedive in emerging markets around May, portfolio inflows have resumed, and an MSCI index of Asian markets outside Japan recently reached its highest level since May.

Clearly, the appreciation of several Asian currencies in tandem has something to do with newfound confidence in the region's stockmarkets. In May, when the emerging markets collapsed, the fear was that rising interest rates in the United States would lead to money flowing out of Asia.

After all, so ran the logic, the Asian market boom last year had been a product of extraordinarily lax monetary policy by central banks across the world, and by the US Federal Reserve in particular.

That policy had led to new highs in Asian stockmarkets, rising Asian currencies, and a huge build-up of foreign exchange reserves by Asian central banks. A reversal of that easy money policy, it was plausibly argued, would lead to a reversal of all these factors. And, for a time, those fears proved to be right.

But as recent data from the US show, it is by no means certain that the US recovery is here to stay. If it weakens after the presidential election slated for November, there will be a question mark over the Fed's resolve to raise interest rates.

The scepticism in the market about monetary policy tightening can also be gauged from the fact that the US 10-year Treasury note yield is near a five-month low; Japanese 20-year bond yields are also at two-month lows.

In sum, the markets expect liquidity to be abundant for some more time, and they feel that the panic in May overestimated the speed of the tightening.

Further, the US current account deficit for the second quarter has ballooned to a massive $166.18 billion, and dealers believe that this is a signal for the dollar to weaken against Asian currencies.

A weaker dollar is needed to encourage inflows to the US and plug the hole in the current account.

Also, many currency market players believe that China will soon have to revalue the yuan, a point of view underlined recently by the US treasury secretary.

As far as the rupee is concerned, there are indications that the Reserve Bank has been selling dollars whenever the rupee needs to be shored up. On the other hand, it has refrained from buying dollars when the rupee is appreciating.

This is in keeping with the government's top priority right now""getting inflation under check. There are too many uncertainties in the current situation""on the US recovery, and on oil prices, for example""for anyone to predict where the rupee will head in the medium term. But right now a slight hardening seems to suit Indian policy-makers quite well.