Currency market update

The softness of IIP numbers and fresh EU problems is changing the short term direction of the Indian rupee. The Indian rupee, an emerging nation currency, has hitherto been appreciating on interest rate differential and rise in capital account inflows.

We have been under a weak current account on rise in imports and moderate growth in the export sector, due to weakness in the developed market.

India’s current account deficit is near to 3%, rising from almost 1.5% in 2007. As per RBI, the current account deficit would be in the region of 3-3.5 per cent of the gross domestic product (GDP) this financial year. During the first quarter of the current financial year, the current account deficit has more than trebled to $13.7 billion, while the capital account surplus has risen to $17.5 billion.

The rupee outlook from the domestic front depends on the further developments in the capital account. It largely depends on further quantitative easing by the US or UK.

A big issue for most of the emerging nations which has seen abrupt capital inflows from past few quarters is its sustainability. When the developed market recovers and start looking at interest rate hike, what will be the impact on the capital inflows?

We believe few hot money will be routing back to the DM’s and will put pressure on the emerging currencies and cause threat to different asset classes. Since January, India’s equity and bond markets have attracted a record $33.8 billion in foreign funds. However, during the same period foreign direct investment – which tends to be more long-term than inflows into the stock market – dropped 35 per cent, down to Rs 63,700 crore ($14.4 billion) from Rs 97,600 crore.

From the RBI monetary policy side, we see a pause in the rate hike cycle by the RBI despite inflation is not their comfort zone. Weak IIP numbers is expected to keep the Central bank to take backseat. Policy interest rates have been raised five times since the beginning of March 2010, raising the repo rate by 125 basis points and the reverse repo rate by 175 basis points.

Another issue for inflation is that, if it doesn’t moderate will cause in competitiveness of the export sector putting pressure on the current account.

From the global fundamentals, the fresh public finance issues from the PIGGS nations is expected to pull down gains of high yielding currencies. Investors in the DM may look for US dollar as flight of despite weak fundamentals.