Dollar swims, euro sinks as rupee stays afloat with RBI peddling

February has been a great month for the US dollar and US stocks. The Dow Jones Industrial Average climbed to record highs. The coronavirus makes central bankers, investors, businesses and citizens nervous but investors have been able to look beyond the virus’ impact. The USD is king because coronavirus helps the dollar as it shines a light on the country’s resilience and draws in safe-haven demand. While US data has been mediocre, we haven’t seen extensive deterioration and that has been enough to reassure investors that while not immune to China’s troubles, the US economy will outperform.

However, the disease is another challenge to the export-driven model of the European Union, which was already struggling towards protectionism. It could be the first big test for Christine Lagarde, who has been optimistic about the euro area’s prospects. Coronavirus will affect Europe’s economy in three ways.

First, there’s demand: China is the third-largest importer of goods and services from the eurozone, after the US and the UK. A slowdown in China sales will cause trouble in a number of industries such as luxury.

Then there’s supply. Europe’s manufacturing supply chains are less exposed to China than is the case for other regions of the world. However, it notes that some industries like automobiles are more exposed. The Wuhan area, where the virus originated, is a major automobile hub and home to production sites of some European carmakers. If the slowdown continues, it can severely impact the automobile sector.

Eurozone woes

Finally, the European Union’s economy is already very weak. Growth slowed to just 0.1 percent in the last three months of 2019, the worst quarterly performance since 2013. From Germany to Italy, the industrial sector had a gloomy end to the last financial year. Unemployment continues to fall but wage growth remains solid, which should support internal demand. However, the euro area has been exposed to a succession of external shocks. The longer the coronavirus episode lasts, the higher the risk it spills into their economy.

Domestically, the RBI’s efforts and tools for the transmission of rates had not brought any significant results until the last monetary policy. The RBI has done an aggregate repo rate cut of 135 bps so far which had little impact to boost growth in the economy so far. Later it came up with four debt-swap auctions termed as “operation twist”, wherein the central bank had purchased long-term sovereign bonds and sold short-term bond maturities up to an amount of Rs10,000 crore each. Yet there was merely a little that was transmitted to the markets. However, the last policy’s twist brought by the RBI without cutting the existing repo rate made some significant changes in below-given aspects amidst the scenario of higher retail inflation:

• The RBI has achieved its objective of lower interest rate regime which had resulted in a significant fall in long-term bond yields from 6.66 percent a month ago to 6.36 percent.
• Stability in the rupee exchange rate.
• Significant fall in the forward dollar premiums.
• Reduction of spread between repo rate and 10-year G-sec yield.

After witnessing that the transmission of the repo rate cut was not passed on to the borrowers even to the extent of 50 percent of the repo rate cuts, the RBI in a surprise move announced that it would conduct LTROs for an amount up to Rs1,00,000 crore for one-year and three-year tenors. The RBI notified that the LTRO amount of Rs 25,000 crore for a three-year tenor will be conducted in this week followed LTRO of Rs 25,000 crore for a one-year tenor in the succeeding week.

RBI intervention

The announcement of LTROs by the RBI triggered a sharp down move in the short-term and long-term interest rates, giving the benefit of lower interest cost to borrowers. The benchmark 10-year sovereign bond yield trading at 6.36 percent and the credit spread between the repo rate and the 10-year sovereign bond yield has contracted by 46 bps in the last two months. Reduction in the spread will take away the cream that banks were earning by not passing it on to the borrowers. This will automatically force banks to lower their interest rates and pass on the benefit to end borrowers. The RBI could accomplish its motive up to some extent, but however, still, the spread is around 120 bps which is higher than the RBI’s target to bring it to 80-85 bps. Other than that, the fall in the one-year forward dollar premium from 4.23 percent to 3.82 percent, have given the benefit of lower export financing cost to the exporters. Also, over a period of around one year, the USD Libor for various maturities up to one-year is also gradually dipping with one-year Libor falling from 2.88 percent in March 2019 to 1.79 percent as on date; thereby additionally reducing the cost to the exporters.

This along with the fall in the crude prices has somewhere relaxed India’s import bills, thereby keeping the deficit in check.

Despite all of this, a question that arises in the mind is why is rupee not appreciating? Is rupee at 71.00 fairly valued? Well, as compared to the fundamentals and recent inflation-growth dynamics, rupee is in an overvalued zone between a 70.70-71.50 levels. This valuation in the currency is mainly due to robust inflows in the Indian debt and stock market as to the outside investors, India seems to be a better investment opportunity among other emerging markets. Hence, the RBI is taking full benefit of the valuation in the pair and has taken control of the rupee by acting as a sole benefiter of the opportunity that arises in the form of dips near 70.80-71.10 levels.

It looks like the apex bank is hoarding reserves as prevention to any upcoming headwinds which will then be used as a ‘Brahmastra’ to protect the exchange rate from any severe attack arising out of geopolitical calamities. Therefore, it is less likely that the pair will appreciate beyond 70.80 and depreciation if any, will also be limited to 72.20 on the back of strong foreign flows.
Amit Pabari is the MD of CR Forex Advisors.