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Monday, Oct 14, 2002

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Rupee's strengthening trend may continue

V. Ravi Kumar

THE strengthening trend continues for the rupee as it hit another new closing low for the financial year. Going forward, there seem to be very little triggers that may cause a change in this trend.

As we move forward and into the last quarter of the year, if the rising trend in inflation continues, this may be a trigger for some rupee weakness. Again, on the back of a slowing global economy, exports may slow down causing some sort of weakness for the rupee by causing imbalance in the trade balance.

But as the rupee continues to appreciate and gets close to and below the 48.25 levels, it will have fully adjusted to its REER (real effective exchange rate) levels and the policy imperatives of keeping the rupee competitive on the export front will be at the forefront of the policy makers in our country.

Thus, as the rupee breaks comfortably past 48.35 and approaches its next big levels at 48.25, it should be fairly valued in REER terms and therefore the reasons for it to appreciate further will be that much weaker.

The attractive differential in the interest rates between India and the US/Euro-zone has been one of the dominant factors that have caused the heavy inflows into rupee deposits. In order to stem the flow somewhat, given the REER implications as discussed above, the RBI may be tempted to cut rates in order to reduce the interest rate differentials.

Indeed, in order to mop up the foreign currency induced liquidity in the system, RBI has had to borrow huge amounts in the daily repo over the past few months.

This brings us nicely to the issue of where the forward premiums are headed. We saw all segments of the curve trading below the 4 per cent mark this past week and given the dispensation to lower interest rate differential as argued above, the likely direction of the premium is further south.

MIFOR-linked swaps have been the guiding star for forward traders over the past few months and the 5-year MIFOR swap has hit close to 5.75 per cent in recent days from the 6-plus levels not so long ago.

Expectations of a cut in rates have gathered steam in the Government securities and corporate bond markets. These expectations have compressed yields on the benchmark 7.40 per cent 2012 bond to about 7.09 per cent, a record, from its recent range of 7.15-7.25 per cent. Expectations of a cut in the forthcoming credit policy are so strong that we have seen a contraction on spreads on almost all instruments in our financial markets.

To cite just one example, the spread between corporate bond yields and G-sec yields narrowed to about 70 basis points from about 125 basis points just at the beginning of September.

The overnight indexed swaps, which we referred to as the guiding star earlier, has already factored in a 50 basis point cut in the repo rate. It is difficult to see a cut in the bank rate now as given the uncertainties prevalent at the moment the RBI would like to deliberate more on the level of bank rate before it actually cuts it. Even if this were to happen, the policy should contain enough pronouncements about the softening bias in interest rates to keep bond rates buoyant and the market expectant of further cuts down the road.

The yen fell close to four-month lows against the dollar after the Bank of Japan announced it would buy up to 2,000 b ($16.5 b) of shares from banks. The BoJ also urged the Government to use public funds to accelerate the disposal of banks' non-performing loans.

But the currency impact, in the shorter term, is likely to be a weaker yen as the authorities seek to offset the negative impact of the reforms on the economy.

Against the other majors, the dollar seems to be confined to ranges. This scenario is likely to continue as long as equity markets are volatile.

Fund managers, who have large levels of volatility to manage in their equity portfolios are concentrating their energies on managing their equity exposures and seem to have lower appetite for currency risk.

(The author is Head, Treasury, at Vysya Bank, Bangalore. The views expressed are his own and not necessarily those of his employer.)

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