The big story of the last fortnight in the foreign currency markets was the vicious fall in the Euro and the collateral damage caused to the INR. The Euro fell by around 3.3 per cent over the fortnight. European sovereign risks were back on the markets’ radar screens due to renewed concerns about the possibility of Greece defaulting on its debt in the near term. The credit markets were pricing in a 90 per cent probability of such an event. But it wasn’t just the fear of default alone. The Euro was also a victim to a change in the monetary policy stance of the European Central Bank (ECB) as the bank’s rhetoric switched from justifying monetary tightening to accommodating fiscal overstretch.
One of the reasons for the Euro’s strength over the past year was the fact that ECB was one of the few G7 central banks that hiked policy rates (by 50 basis points). The central bank is known to have a narrowly defined inflation-fighting mandate that often overlooks growth concerns. This brought in “carry trades” into the currency, funded by the relatively cheap dollars that the Fed’s continuing zero-interest policy ensured. However, recent weakness in Europe’s core (Germany, France) coupled with an austerity driven recession in the periphery forced ECB to change its position. In a statement last fortnight, ECB acknowledged that “downside risks to growth had increased while the risks to inflation were broadly balanced”.
The bottom line: it will try and prop up the real economy through monetary easing, perhaps a rate cut in the near future. This would undo the interest arbitrage working in its favour. Besides, given the growing risk of sovereign default, it would continue to buy sovereign bonds (particularly Italian and Spanish bonds) to keep default risk at bay. The surprise resignation of ECB Executive Council member Stark, who is considered one of the most hawkish members, was also viewed as an affirmation of a change in ECB’s stance. The upshot is that ECB’s balance sheet is likely to expand further, pulling the exchange rate down.
However, anxieties over Greece and its patently-unsustainable debt burden perhaps played a bigger role in knocking down the Euro. Once again the Mediterranean nation struggled to meet its fiscal targets stipulated in its bailout deal. Specifically, it seems unable to meet its privatisation target that forms the backbone of its fiscal consolidation programme. The inability to stick to austerity measures could mean that the next tranche of funds due at the end of September worth around euro 8 billion could be held back. However, some relief did set in after German Chancellor Angela Merkel and French President Nicolas Sarkozy said the European region remains committed to providing assistance to Greece and in keeping “project Euro alive”.
Despite assurances from Merkel and Sarkozy, questions remain on whether the second bailout package for Greece announced in July this year can actually be implemented. While markets had cheered the deal at that time, for the bailout to come into effect it must be approved by all 17 Eurozone Parliaments. A number of member nations such as Finland, Slovakia, Netherlands and even certain sections of the German Parliament remain opposed to this There are other issues as well — the plan to increase the size and scope of the current European Financial Stability Fund (EFSF) might come a cropper if some of the Eurozone members refuse to play ball. Questions also remain on whether there will be adequate private sector participation in the bond buybacks and rollovers that involve swapping bonds due for redemption into longer dated securities. The bottom line is that European sovereign risks are unlikely to fade away. Upbeat sound-bytes from the likes of Merkel or Sarkozy might provide temporary relief but once the markets do a reality check, it will discover a lot to fret over. From a trader’s perspective, any rise in the currency might be the right opportunity to sell.
The world is flat, especially the world of financial markets. Concerns that the global businesses of European banks will be impacted by the continuing saga in Europe resulted in the capitulation in the rupee and other Asian currencies and assets. A number of central banks including the Korean, Indonesian, Philippine central banks and the Reserve Bank of India have to intervene to stem losses. While the rupee moved in the same direction as other Asian currencies, the sizeable current account deficit ensured that the rupee fell more sharply.
There is a serious problem emerging for the rupee. European banks are major suppliers of foreign currency loans and as European money markets tightened, both the supply of ECBs and trade credit has come under pressure. This is a difficult period for India’s balance of payments. Forty-four per cent of external debt (129 billion dollars if you include NRI deposits) comes up for redemption this fiscal year. If Indian companies can’t roll this over, the tilt in the demand-supply balance sets off a shortage of dollars and consequent depreciation of the rupee.
In the immediate future, the rupee could remain under pressure driven by ongoing uncertainty about the EU sovereign crisis and general concerns about the state of the world economy. However, a reversal is possible by end of the year or perhaps early next year. A number of factors could help. The Fed’s QE 3 programme that a lot of us expect in early 2012 could result in renewed fund flows into the Indian markets. A halt in the domestic monetary tightening cycle and the realisation that the domestic economy is merely slowing a tad and not falling off a cliff could get portfolio managers to seriously rethink their India exposure. Stock valuations have come off quite a bit and it might not be long before words like “compelling” and attractive are once again used to describe equity valuations in India. A moderate improvement in global risk-appetite could see the rupee moving back to the 45-46 band.
The writers are with HDFC Bank.
These views are personal
