Column The task at RBI

Written by Indranil Pan | Updated: Sep 20 2008, 06:10am hrs
The global currency market dynamics have changed rapidly from the beginning of August. After pushing up to 1.60 on the back of economic woes in the US (and sentiments that the ECB could go for further rate increases), the Euro crashed against the dollar from the first week of August.

The first trigger for the depreciation of the Euro came on August 7th with Trichet acknowledging a slowing EU at the press conference after ECBs rate setting announcement. On July 11th, when the global crude oil prices were at their peak, the dollar-Euro was quoted at around 1.59. As Euro started to lose its strength against the dollar, the global crude oil prices also started to fall; a direct realisation of the fact that slowing economic activity would inevitably lead to demand erosion in crude oil. After the ECBs rate setting meeting on August 7th, the Euro had depreciated by nearly 4% to 1.5325 and moved on rapidly to depreciate by a further 9% to 1.3944 by September 11th.

What is surprising is that the US dollar has mostly held on to its recent gains even as the financial market stress reemerges. Kenneth Rogoff, former Chief Economist at the IMF had pointed out recently that the worst is yet to come in the US and may topple some of the biggest banks in the US. May be the Fed would not be willing to let any bank fall easily, but the same is not true for the investment banks as the recent evidences show. With the housing market showing no signs of having yet bottomed out, the stress on the financial system continuing, with the unemployment rate high at above 6% and also possibly inching up, the next reaction from the Fed could well be a reduction in the policy interest rates.

However, what is probably safeguarding the dollar is the news that major central banks have announced massive injections of dollar liquidity and that the Treasury and the Fed would establish a fund to buy bad debts off the financial system. Thus the assumption is that the financial market uncertainty will soon evaporate.

In Europe, industrial production trends have been rapidly weakening in Germany, France and Italy and with the EU PMI tipping below the crucial 50 mark, retail sales growth was on the slide in the major EU economies. Growth in Germany that accounts for 25% of total EU GDP fell sharply in Q2 (de-growth of 0.5% as against a growth of 1.3% in Q1). And it was the first time since 1995 that the quarter-on-quarter growth was negative for the EU as a whole. Even as the ECB continues to remain nervous on a wage-price spiral at the moment, eventually the sharp drops in the crude oil and commodity prices will lead to the inflationary targeting ECB to cut policy rates to address the slowing growth.

Thus, even as the global currency markets are expected to exhibit significant volatility in the near term, the longer term direction for the euro, especially into 2009 or even into 2010, remains negative. This is possibly due to an understanding that the US Fed is now much ahead of the monetary easing process when compared to the other central banks of the world. Put simply, the US could be the first to emerge out of this global recessionary trend and then the dollar will have a chance of resurrecting itself once more as the number one currency of the world. But right now the only missing link appears to be the supportive factor of a rate hike by the US Fed. Hence the path for a resurrection of the dollar as the number one currency of the world would definitely be bumpy.

What does all of this mean for the Indian currency The Indian currency has been hit by a sudden and sharp rise in the international crude oil prices. From a low of around 39.20 in October 2007, the Indian Rupee steadily depreciated to 42.88 in mid-July as international crude oil prices hit a peak. But the link between the rupees weakness and global crude oil prices has completely broken off. Oil prices significantly corrected lower but instead of gaining in strength, the rupee weakened sharply. The changed market dynamics of the global currency markets hit the Indian rupee as the dollar strengthened sharply other currencies. High domestic inflation (that necessitated a rupee depreciation to maintain export competitiveness) also served to weaken the

Indian rupee.

The RBI today is clearly trying to smooth the depreciation pressures and hence has announced steps to improve the supply of dollars (increasing interest rates to be offered on FCNR(B) and NR(E)RA deposits). Further boosts to dollar supplies could come in the form of relaxations in the ECB guidelines. Furthermore, inflation is yet to correct significantly lower and monetary policy tightness is expected to persist, providing some scope for the Indian rupee to regain some lost ground.

However, there would be significant limitations as regards the extent to which the rupee can appreciate. In the longer term, the rupee should stay a depreciating currency as the dice remains loaded for a strong dollar over an extended horizon. As the dollar is resurrected as the number one currency of the world the flow of funds would remain in favor of dollar assets and relatively lesser in favor of the emerging market assets.

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