20 December 2005

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Wow! Has the rupee arrived?

The charts overleaf shows the volatility of the rupee over the past couple of months; the second chart shows that the 90-day volatility of the rupee has risen steadily and now stands less than 2 percentage points or so below that of the yen. For one who has long been advocating the need for higher volatility in the forex market, this should come as a breath of delight.

However, the unfortunate problem is that while volatility has risen admirably - and, to judge from RBI's hands off approach, it would seem that they are quite happy with the rise - there hasn't been an attendant increase in market liquidity. As a result, there's a fair amount of shell-shocked bemusement in the market and, of course, a certain amount of blood on the streets.

The good news is that the recent surge in the rupee came right on the heels of its sharp collapse since October, after which most companies were simply holding on to their pain. Thus, the leveraged option positions that many companies had entered into, which were looking at multi-crore cash losses, when the rupee had crossed 46, are now a bit easier to take, albeit still losing money. Importers, who had been watching wide-eyed as the rupee fell, and, analyst after analyst started calling for it a return to rupee weakness, are breathing easier again, and, importantly, have started covering around the 45 - 45.25 level.

Further, this sort of wild ride drives more and more companies to try and build more effective risk management processes - setting objective benchmarks, risk-based decision-making, performance attribution, etc. - which is all to the good. Of course, it is rather like strengthening damage control processes after the storm has passed, and I think it is incumbent on RBI to recognize its hand - albeit passive - in all of this.

Globally, liquid forex markets trade at around 100 times underlying merchandise trade. In India, with the daily turnover around $ 12 bn and annual trade volumes at about $ 200 bn, the ratio stands at around 15 - respectable, for an emerging economy, but still hugely shy of where we need to be. In particular, with the economy growing like gangbusters, the needs of the market are for substantially higher liquidity - say, twice the current levels - at once.

The thinness of the market is without doubt the cause for the speed with which the rupee rose over the past two weeks. We note that from December 8, the rupee has risen by 3% (to its current peak of 44.96), much more than the Euro (2.2%) and a bit short of the yen (3.4%). From these numbers, it would seem we were living in a totally free market. But the reality is that the sharp rise starting from the 8th was driven by a (reported) $ 500 million inflow from the ICICI ADR issue, with most of the action in the inter-bank rather than any broad based dollar selling. Indeed, the forward premiums actually rose indicating dollar buying by corporates once the rupee reached near 45. A more liquid market would have seen more congruent action, providing something of a stabilizer to such sharp movements, which would give end-users of the market more opportunity to sell (in this case) at the higher levels.

In any event, the overall increase in volatility is a good thing. There will doubtless be more conservatism in the user community, an increase in option volumes, and, importantly, a large move towards more structured risk management practices.

It would be really great if RBI were to rise to the occasion and provide another bolus of deregulation. The first steps are obvious - permit short selling in the gilts market, increase the individual limit for overseas investment to (at least) $ 100,000, and widen access to the forex market to all players currently permitted to access the debt market.

C'mon - let's go!.

Currency Markets View: Rupee and Majors

INR

Fortnightly movement: O-46.18 H-46.39 L-45.32 C-45.34.
Sentiment: responding to dollar weakness overseas
Expected range for 1 Month: 44.75-46.00
Expected range for 3 Months: 44.50-46.50

Rupee entered into a huge corrective phase and recovered about 2% during the fortnight to close 84 paise stronger at 45.34. Broad Dollar weakness in the overseas markets and good foreign capital inflows were the major factors helping in the Rupee recovery. Big unwinding in Dollar long positions in the overseas markets (year end profit booking) was triggered after US Federal Bank in its latest meet shifted its stance from accommodative to neutral region, signaling a possibility of a pause in the interest rates hikes in first half of 2006. FIIs increased their exposures further by USD 871 million in the month of December, taking their total investment to a record USD 9.5 billion in Indian equity markets in the calendar year.
We expect some more year-end Dollar long position unwinding in the overseas markets, which may strengthen Rupee to near 45 levels where import demand is expected to limit further Rupee gains. Dollar demand is expected to get further momentum once Dollar decline pauses in the overseas markets.

EUR

Fortnightly movement: O-1.1715 H- 1.2059 L-1.1686 C-1.2008
Sentiment - good and will probably improve
Expected range for 1 Month: 1.1875 -1.2300
Expected range for 3 Months: 1.1875-1.2600

Trapped in a narrow range under 1.1850 during the week before last, the euro rose smartly last week as high as about 1.2060 due to several factors. The Fed's statement accompanying last week's rate hike has created uncertainty about future rate hikes by implying that its monetary policy is no longer accommodative. On the other hand, the ECB President commented hawkishly that a central bank ought not to wait for inflation to materialise before taking any action. US trade deficit rose unexpectedly to a record $68.9 bn. US headline CPI fell 0.6% while the rise in core CPI was benign. From the Eurozone, German IFO business confidence index rose more than expected. Consequently, the euro was able to shrug off upbeat US data such as the TICS report showing net capital inflows of $106.8 bn, a strong rise in industrial production for a second consecutive month and improvement in the Philly Fed manufacturing index.

From a technical perspective, the euro appears to have entered a corrective phase which could last for a couple of months at least. Barring an unexpected decisive decline below 1.1875, the euro is likely to rise to about 1.26 before resumption of the downtrend.

GBP

Fortnightly movement: O-1.7319 H- 1.7807 L-1.7271 C-1.7722
Sentiment: good and will probably improve
Expected range for 1 Month: 1.7300-1.8000
Expected range for 3 Months: 1.7300-1.8300

Except for an intraday dip to about 1.7270, sterling managed to stay above the 1.73 support level before rallying as high as about 1.78. Apart from the uncertainty about future Fed rate hikes and the negative US data, sterling was propelled upwards additionally by Bank of England's decision to keep interest rates on hold, strong UK retail sales figures and slight improvement in the total orders position of British manufacturers.

Strong support in the 1.73-1.75 area may enable sterling to rise to 1.80 within a month and thereafter to 1.83 before resumption of the downtrend.

JPY

Fortnightly movement: O-119.15 H- 121.20 L-118.20 C-120.48
Sentiment: very good (for yen) and may remain so
Expected range for 1 Month: 113.75-119.00
Expected range for 3 Months: 109.00-119.00

The dollar stayed well over 120 yen during the week before last but suffered a near collapse last week when it fell over 5 yen. The Fed's shift to a neutral stance, the negative US data, a strong Tankan report from Bank of Japan on Japanese business sentiment and the BoJ Governor's hawkish comments hinting at an end to the quantitative easing policy, appears to have led to a stampede in squaring up of 'carry trades' i.e. short yen positions against all high yielding currencies and especially against the US dollar.

Resumption of the dollar's uptrend seems unlikely before the recently seen bullishness has evaporated completely. USD/JPY declines are usually sharp and swift and quite often reach a near-panic stage. While 109 yen is a reasonable target over a 3-month time frame, don't be shocked if the dollar falls further.

N.B. Beware of higher volatiliy in thinning, year-end market conditions.

Interest Rate Markets

Bond yields crept up yet again as tight money conditions prevailed in the market. Cash surpluses dwindled steadily on account of outflows towards advance tax payments of about 20000 crores. The overnight call money rates were quoted in the range of 6.20-6.30%, just about the repo rate. The repo window received bids above Rs.6000 crores (repo rate: 6.25%) even as the reverse repo bids slipped to low of Rs.3400 crore.

Concerns that redemption of $7.3 billion expatriate deposit scheme (issued by SBI five years ago) this month-end would add to liquidity crunch induced selling across the curve. Volumes in the gilts market fell (average: 400 crore) as investors opting to stay on the sidelines ahead of year-end. The actively traded 8.07% 2017 bond witnessed trades of only Rs. 80 crore, raising he yield marginally 7.22%. Some temporary gains were seen during the fortnight, owing to a rally in US Treasuries and easing of global crude prices.

Industrial production rose by 8.5% in October expanding at its fastest pace in four months. Lending rates are perceivd to be under pressure. Rise in cut-off yield on 91-day T-bill to 5.78% from 5.65% underlined concerns.

Government borrowing programme is almost over and only Rs. 24000 crore of debt will be issued last quarter of he fiscal.

US Treasuries drove on a slight twist in Federal Reserve's monetary policy statement and climbed sharply across the curve. The Fed removed 'accomodative' from its statement but reaffirmed view that economic activity remained strong despite particularly damaging hurricane season. Core inflation and long-term inflation is seen well contained. They considered underlying price pressures from high crude prices posing a risk. The benchmark 10-year note yielded 4.45%, off its high of 4.55% prior to FOMC meet. Spreads between the 2-yr and 10-yr note, continued to be narrow and stood at 7 bps. Market is likely to be range-bound as participants head for Christmas holidays. Besides overseas players have already staked out their positions ahead of the holidays and into year-end.