Column : Appreciate or depreciate

Written by Indranil Pan | Updated: Dec 30 2008, 04:04am hrs
2008 was one of the most volatile periods in the history of the international currency markets. There was a phase of weakness in the dollar that extended from 2nd half of 2007 to the first half of 2008 calendar. However, as the oil price retreated from its peaks, it brought the US dollar off its lows against the euro. Ironically, the strongest phase of dollar appreciation was also a phase when the mess in the US financial sector was boiling over. The fall of Lehman Brothers triggered a sharp dose of risk aversion that led to falling equities. Flight of safety to the US Treasury bonds was the name of the game and while the US treasury yields fell sharply, dollar appreciated against the euro. From a low of 1.60 on 22nd April 2008 against euro, the dollar appreciated by nearly 22% to its peak of around 1.25 by October 27, 2008.

This phase of the US appreciation did not sustain, probably as market participants realised that there were no positive fundamentals backing the sharp dollar appreciation and that this was only due to the de-leveraging. The euro strengthened against the dollar as the greenbacks own vulnerabilities came to the fore and the dollar depreciated by 16% against the euro to 1.44 from its peak on October 27, 2008. With the US interest rates pushed to near zero, it has reduced the incentive for investors to hold US dollar denominated debt assets. The question going into 2009 is whether this round of depreciation of the dollar against the euro will sustain.

For the moment the Fed is pursuing a looser monetary policy than Europe. Moreover, ECB is indicating a cautious approach in reducing policy rates. However, I feel this may not last long and the 15 nation Eurozone is sinking fast into a slowdown that could be the worst since World War II. The problem for the region is a lack of political unity as also a diverseness of economic conditions across the economies of the region. It is more or less clear now that the governments role is of significant importance in preventing a complete breakdown of the financial system in any of the affected economies. And this is where the European region may be found wanting.

These factors probably would explain why the euro (that at some points aspired to be an alternative to the US dollar) has faltered in the recent months. The dollar will still be the most important currency of the world with the sizeable and liquid US treasury paper market.

What does this mean for the Indian currency against the dollar At the peak of de-leveraging, Asia as a whole was caught in a sell currency, sell equity mode. Most Asian currencies, including the rupee depreciated significantly and most Asian central banks were forced to intervene to support their currencies. For the moment, global equity markets, and Asian markets, are much less volatile but this stability should not be considered as the base for a round of sustained rebound. There may be more deleveraging, resulting in the dollars strength. With the movement of the rupee against dollar now closely reflecting the dollars strength/ weakness against the euro, the rupee is likely to weaken against the dollar in phases.

Further, I am not expecting significant increases in foreign fund inflows into India immediately. For 2008-09, I see the balance of payments in deficit but for 2009-10 it might just be square. The sharp dip in international crude oil prices can provide some breathing space on the current account but remember that exports are also crumbling. Further, global financial institutions will continue to be in a de-leveraging mode. The definition of risk-capital is likely to undergo a sea change with greater regulatory hold on financial institutions globally after infusion of government funds in these institutions. Finally, the risk perception on emerging market economies could also undergo some change with rising fiscal deficits etc. Finally, I think 2009 will possibly be another year of significant volatility in global currencies markets. The rupee will also remain volatile against the dollar but any major appreciation is unlikely.

The author is chief economist, Kotak Mahindra Bank. These are his personal views