Abheek Barua & Shivom Chakravarti: Markets back to square one
Quite surprisingly, neither the formation of a pro-bailout Greek government nor the European Union (EU) lifeline of a hefty euro 100 billion to the Spanish banking sector inspired confidence in the markets. For one thing, there are doubts about whether Greece’s ruling coalition would remain committed to implementing the various austerity measures that the bailout is contingent on. Thus, the election result may have deferred Greece’s exit from the currency union, but it hasn’t guaranteed that the country will not leave the union in future. Second, if Spanish banks do indeed get assistance from the European stability mechanism, they would have to float recapitalisation bonds that could get “senior" status in the hierarchy of claims on debt. This would lead to the “subordination" of th existing debt of Spanish banks, and holders of these bonds are naturally concerned that this slide down the ladder of claims means a higher risk of not being paid back.
There are bigger concerns as well. Markets continue to fret more about the long-term viability of the euro project itself and are demanding a more concrete set of measures aimed at ensuring greater fiscal integration rather than the stop-gap measures that are currently being employed. Some of the measures that are on the market’s wish list are a move towards issuing common “eurobonds" (in place of individual sovereign issues), an integrated deposit insurance scheme for banks across the region and a more comprehensive rescue framework to recapitalise the European banking sector.
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Going by recent comments from European politicians, a decisive move towards a fiscal union seems unlikely in the upcoming EU summit. The impasse is likely to continue in the coming months. The failure to reach a political consensus to resolve the crisis could trigger another round of acute risk aversion. The upshot is that the failure of European policymakers to deliver will once again put the onus back on the two major global central banks – namely the European Central Bank (ECB) and the Federal Reserve (Fed) – to resurrect the financial system. The key question is will they play ball?
Past actions taken in response to an escalation to the sovereign crisis over the last two years do suggest that some possible relief could be in the offing. Over the last few months, ECB has been reluctant to turn on its money machines primarily because it wants to pressure member nations to get their act together and make the necessary fiscal adjustments. That said, it continues to express concerns about the outlook for growth and financial markets. Given the choice of either watching the European financial system crumble or taking action, we expect ECB to lean towards the latter. Another long-term refinancing operation accompanied by interest rate cuts is possible in the next few months if European policymakers fail to instil confidence in the financial system.
The US Fed, on the other hand, has already made it clear that it will respond to financial stress that threatens to undermine growth in the US economy. Hence, a third round of quantitative easing towards the fourth quarter of 2012 seems highly likely.
Do global developments really matter for the rupee anymore? In recent weeks, the rupee has maintained its losing streak irrespective of the ups and downs in global risk appetite. Some of the sharp fall over the past few days could have something to the do with the Reserve Bank of India’s (RBI’s) interim monetary policy announced on June 18.
One interpretation of RBI’s statement is that it is somewhat comfortable with rupee depreciation. A fall in the rupee acts as de-facto monetary accommodation, stimulating exports and trimming the imports bill by encouraging import substitution. This stance was in keeping with its recent actions in the currency markets where its intervention has, at best, been patchy, and administrative measures (like directly supplying oil companies from its reserves) absent.
Given the current momentum and RBI’s admission that it prefers to stay on the sidelines, the rupee could easily weaken all the way to 58 against the dollar. However, at current levels, the rupee does appear to be extremely oversold and a possible reversal cannot be ruled out on account of a variety of factors. For one thing, oil prices have fallen sharply by around 18 per cent (Brent crude oil prices) in the last month alone. This is likely to translate into a lower oil importbill and a decrease in the amount of dollar demand that would automatically correspond to an improvement in the rupee’s performance.
Second, sentiment towards domestic assets could reverse after the presidential elections in July since it would give the government space to press ahead with at least token gestures towards reform. Sentiment has reached a nadir as far as Indian assets are concerned and even the mildest bit of good news could induce a pick-up in fund flows. If all this coincides with, or is followed by, global monetary accommodation, there could be sustained support to the rupee. Importers might want to hedge their near-term exposures but over a slightly longer horizon, could hope for a reprieve.
The authors are with HDFC Bank. These views are personal