Possibility of increase in risk aversion may hurt Re’s prospects

Financial markets’ run with optimism continued last week. The global equities market got a boost from the US Treasury’s plan to buy toxic sub-prime related assets from banks with the help of private investors.

That helped improve risk appetite among investors. Action in the currency market was also influenced by a debate about moving to an alternative currency for holding foreign exchange reserves. The debate was started by the Chinese central bank’s governor who proposed that US dollar could be replaced with International Monetary Fund’s (IMF) synthetic currency - the Special Drawing Rights (SDRs) - as the world’s reserve currency starting with greater role for it in the international financial system.

That heightened volatility in the US dollar, but the greenback finished the week on top. The greenback was buoyed as the US Treasury announced plans last Monday to use $1,000 billion to remove toxic assets from the balance sheets of capital-starved US banks.

The dollar took centrestage as the impact of the Treasury’s plan rekindled optimism about US efforts to boost economic growth. The plan to remove toxic assets from the banking system will inject capital and allow banks to resume lending.

The US dollar even managed to survive a sharp sell-off on Wednesday after Timothy Geithner, the US Treasury secretary, said he was “open” to China’s proposal to replace the US dollar as a reserve currency with IMF’s SDRs. Geithner clarified his view later, saying that he expected the greenback to remain the world’s reserve currency for a long time to come.

The rapid price action following his initial comments, however, underlined market sensitivity to this issue ahead of the meeting of the leaders of the Group of 20 developed and leading emerging economies this week. Subsequent comments from several G-20 participants affirmed the dollar’s reserve currency status, easing pressure on it. Over the week, the US dollar rose 2% against the yen, gained 1% against the pound and climbed 1.5% against the Swiss franc.

The greenback advanced more strongly against the euro, rising 2.1% on the week as German finance minister Peer Steinbrück warned on Friday that fiscal expansion in Europe could put the single currency at risk. The euro also dropped 1.1% against the pound over the week and eased 0.1% against the yen.

Improved risk appetite boosted the currencies of commodity producing countries. The New Zealand dollar rose 1.8% against the US dollar over the week while the Australian dollar climbed 1%. Elsewhere, the Norwegian krone sold off sharply, as the country’s central bank cut interest rates.

The krone has been the best-performing leading currency so far this year, attracting safe-haven demand due to current account and fiscal surpluses and the perception that the Norges Bank would not adopt quantitative easing. But the krone’s safe-haven status was brought into question after Svein Gjedrem, governor of the Norges Bank, indicated that intervention to stem the krone’s rise was an option if the currency moved “out of line”. Over the week, the krone dropped 4% against the US dollar and fell 1.7% against the euro.

In the local inter-bank market, the rupee’s gains were restricted by a rebound in the US dollar overseas. With BSE Sensex rallying by 12% over the week, there was significant support to the Indian unit from the equities market.

However, with the greenback gaining ground against other Asian and major currencies, market participants chose to remain long on the US dollar. Over the week, the rupee-dollar pair traded in the range of 50.19-51.10 and finished the week almost flat. The rupee lost ground against the greenback mid-week but recovered later.

This week, the market focus will be on the G-20 meeting in London on April 2. In the run-up to this meeting, market participants have built expectations of a coordinated action plan by the G-20 nations to revive the global economy and stabilise the financial system.

However, there is a difference of opinion among the major developed countries, with US and UK calling for more fiscal stimulus from other countries, but members such as Germany seem to be against it. Thus, there is some risk that no tangible and coordinated plan comes out of this meeting. If that happens, we could see the recent optimism in the market disappearing rapidly and risk aversion coming back into action.

In the local market, market participants would look to reassess the recent equity market rally. With little positive support around to continue this rally and uncertainty increasing due the national elections, there are chances that the equities market could see some downward correction.

That would be negative for the rupee. If, however, the outcome of the G-20 meeting is positive and helps improve risk appetite further, then the equities and the rupee can get some more support, especially from foreign portfolio flows. Otherwise month-end demand for dollars and a short trading week could lead to heightened volatility in the rupee-dollar pair. The US dollar could also hold on to its gains for most of the week, which would put downward pressure on the rupee. Overall, the rupee-dollar pair can trade in the range of 50.50-51.25 with a weakening bias for the rupee.