The rupee will stay weak in the range of Rs 48-52 against dollar

There is a broad trend towards “safe haven” assets, including the US dollar (USD) after the US Federal Reserve meeting held on 21 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 10-year benchmark treasury yields closing at 1.81 percent levels, lower by 13 basis points (bps, where 100 bps make 1 percent) over the day.

The broad USD rally is affecting the Indian rupee (INR) as well, with the INR falling by 0.8 percent post the Fed meet. Around noon on Thursday, the rupee was trading at Rs 48.75 to the USD. Given the move towards risk aversion, the INR is likely to remain pressured over the short term.

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The USD has rallied against most of the world’s major currencies since the beginning of August 2011. The accompanying table shows the performance of the USD in the August 2011 till date.

[caption id=“attachment_89517” align=“alignleft” width=“380” caption=“The rupee will strengthen once risk aversion start reversing.Flickr/Creative Commons”]  [/caption]

The performance of the INR, the Korean won (KRW), Brazilian real (BRL), and Russian rouble (RUB) against the USD has more or less been similar with all of them losing significantly over the past one-and-a-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 Kaushik Basu who has been calling for rate cuts. The Reserve Bank is better off keeping status quo on rates on the back of INR worries.

The INR has an added problem of the country running a current account deficit. The year-on-year trade deficit has moved up by close to 15 percent 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 foreign inflows (FIIs) into the country. FII flows into equity and debt are down from over Rs 1,00,000 crore seen in 2010 (January- August) to Rs 15,000 crore in 2011. The current account deficit - the gap between foreign earnings against expenses - was at 2.6 percent of GDP in 2010-11 and, given a weakening INR, slowing capital flows and global risk aversion, the deficit can move up by 0.5 percent 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 start reversing. The reason is that interest rate differentials between India and the US are almost 8.25 percent, given short-end rates trading at 8.5 percent in India while US short-end rates are anywhere between 0-0.25 percent. The rate differentials coupled with a weak INR should ultimately attract capital flows.

[caption id=“attachment_89516” align=“alignleft” width=“493” caption=“Table”]  [/caption]

The other reason for the INR to strengthen in the longer term is the growth differential with the US. Growth in the US is slated to be 2 percent and India’s growth could be around 7.5 percent. Portfolio flows will resume once the dust settles.

For now, risk aversion is the buzzword and INR will remain pressured.

Arjun Parthasarathy is the Editor of www.investorsareidiots.com, a web site for investors.