There is a broad trend towards safe haven assets including the US Dollar (USD) post the US Federal Reserve meeting held on the 21st of September 2011. The USD rallied against most of the major world currencies on the back of the Fed not expanding its balance sheet. US treasury yields fell to record lows with ten year benchmark treasury yields closing at 1.81% levels, lower by 13bps over the day. The broad USD rally is affecting the Indian Rupee (INR) as well, with the INR falling by 0.8% post the Fed meet. Given the move towards risk aversion, the INR is likely to remain pressured over the short term.
The USD has rallied against most of the world’s major currencies since the beginning of August 2011. Table 1 shows the performance of the USD in the August 2011 till date period.
The performance of INR, Korean Won (KRW), Brazilian Real (BRL), Russian Rouble (RUB) against the USD has more or less been similar with all of the losing significantly against the USD over the past one and half months. The performance of the BRL is worse than the performance of the other currencies due to the rate cut effected by the Brazilian Central Bank last month to counter global growth effects on the economy. The poor performance of the BRL due to rate cuts should be noted by Mr. Kaushik Basu who is calling for rate cuts. RBI is better off keeping rates status quo on the back of INR worries.
The INR has an added problem of the country running a current account deficit. The year of year trade deficit has moved up by close to 15% in August 2011 and with a weakening global economy, a widening trade deficit is not likely to be bridged by flow of invisibles. Capital flows can negate a widening current account deficit but the risk aversion globally has affected FII flows into the country. FII flows into equity and debt are down from over Rs 100,000 crores seen in 2010 (January- August) to Rs 15,000 crores in 2011. Current account deficit was at 2.6% of GDP in 2010-11 and given weakening INR, slowing capital flows and global risk aversion the deficit can move up by 0.5% in 2011-12.
The question is how much further will the INR weaken and will it reverse trends when things settle down. The answer to the first question is difficult to pinpoint as risk aversion trades can take irrational proportions. The dust can settle anywhere between Rs 48 to Rs 52 to the USD if the INR selling gains momentum. The answer to the second question is easier, the INR will strengthen once risk aversion trades start reversing. The reason is that Interest rate differentials between India and the US is at almost 8.25% given short end rates trading at 8.5% in India while US short end rates are anywhere between 0% to 0.25%. The rate differentials coupled with a weak INR will attract capital flows. The other reason for the INR to strengthen in the longer term is the growth differential with US growth slated at below 2% and India growth slated at 7.5%. Portfolio flows will resume once the dust settles.
For now, risk aversion is the buzzword and INR will remain pressured.