Column : Rating the exchange rate

Written by Indranil Pan | Updated: Mar 25 2009, 06:58am hrs
The global currency markets never fail to surprise. Not too long back, the market appeared to be unanimous about the US dollar being doomed and data from the IMF indicated reallocation of currency reserves towards the euro and away from the dollar. But as ECB acknowledged that the eurozones economy is far from stable, the dollar appreciated on the back of de-leveraging and safe haven arguments that led to a belief that the dollar is probably headed towards parity against the euro, despite all gloomy news emerging out of the US.

However, this appears thwarted for the moment. News of the US Fed preparing to buy $300 billion of longer term US government debt in addition to buying agency mortgage-backed securities and agency debt has triggered a fall in the dollar. The principal and immediate reason for its sell-off was the perception of an increased supply of dollars by the Fed as it buys treasury securities and other bonds. The treasurys announcement of the Public-Private Investment Programme that will clean up toxic assets from US banks balance sheets is also likely to have negative bearings for the dollar.

Indian monetary authorities will likely heave a sigh of relief as the pace of the recent depreciation of the rupee against the dollar is arrested. RBI might not be keen to allow for sharp depreciations as this negatively impacts the debt servicing of Indian entities in rupee terms and also erodes the confidence of international investors. But, arresting the depreciation would imply cranking up on rupee liquidity.

The relief for the rupee may be short-lived. First, I expect the dollar to return to strength over time. The recent spate of appreciation of the euro against the dollar is unlikely to suit Eurozone economies as this is equivalent to monetary tightening and detrimental for exports. With the Fed launching credit easing measures, it will be interesting to see how early the ECB changes its rhetoric of gradual easing of monetary policy, which could trigger a renewed weakness of the euro.

The other big question is: is the crisis over and will another round of de-leveraging not affect global financial markets The current euphoria and risk-loving behaviour of the financial markets is on the back of a belief that a significant chunk of the problem is behind us. But such euphoric reactions were also present as the Fed launched into the rate cutting cycle or as the previous US president announced various mortgage relief plans. From a longer-term perspective, an arrangement of the Fed consistently buying debt issued by the US treasury is unlikely to be sustainable. And more importantly, even as the worlds central bankers try to unfreeze the credit markets, this is not easy. There is no guarantee the banks that are the beneficiaries of all the funding and cleansing programme of the US Treasury will immediately put the money to work. Incidentally, a research note that I read recently indicated that only about 8% of the total money that has been already injected by the Fed has actually been put to use.

Further, the banking system needs to be fixed before the recovery process can be firmly in place. Unless this happen the fiscal and monetary policy supports can only enthuse markets in the short-run. This suggests that the process of de-leveraging and risk aversion is still not over and will lead to a renewed firming trend for the dollar in the medium term. The dollars movement against the euro has played a key role in driving the outlook for most Asian currencies recently, including Indias. As the dollar becomes stronger, the rupee is likely to depreciate against it.

The fundamental domestic picture for the rupee also points to depreciation. Countries with high fiscal and current account deficits are most unlikely to see any sustained appreciation of their currencies. The mainstays of the remittance inflows, namely private remittances and software exports are now weaker. Further, capital flows to emerging markets should remain weak as protectionist forces take shape in light of the significant infusion of taxpayers money into the financial institutions in the western world. Foreign fund flows are also being turned off. For India, the spectre of a sovereign downgrade and elections are likely to further restrict flows. Overall, the rupee will remain weak against the dollar through 2009, possibly testing Rs 52-53 to a dollar.

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