Financial Times

Dollar seen hitting Rs 105
Rupee, not bombs, the worry
Last week's suicide bomb blast jolted the markets but fears that it could jeopardise the peace process were soon discounted leaving investors to worry about the sharp depreciation of the rupee against the dollar that could derail the government's economic programme.

The rupee, trading at around Rs 102.70/75 to the dollar last Friday could hit Rs 105 to the dollar by year's end if the situation does not improve, fuelling inflation in the import-dependent economy, economists and foreign exchange dealers said.

"The trend is for further weakness in the rupee but it may not fall as fast as we have seen in the last 2-3 weeks," said a foreign exchange dealer. "The Rs 100 mark was such a psychological barrier that as soon as the dollar went over Rs 100 everybody began clamouring to buy it (dollars)."

Brokers said the stock market's rapid recovery the day after the bomb blast indicated that investors in the Colombo bourse had matured and had taken the incident in their stride. "Investor reacted initially by panic selling and the market collapsed," said Channa Amaratunga of Asia Capital.

But they took a rational approach when they realised this was an isolated attack on a specific target and the market bounced back the next day. "The bomb blast shows that the tension in the north-east is still very much there and that the LTTE can strike in the city at will," said Amaratunga.

Danushka Samarasinghe of SC Securities said the panic selling spree died down when buyers started coming in unlike on previous occasions after similar shocks when the market took longer to recover. He still expects a market correction and feels that this may happen after the provincial council polls if the government is unable to maintain its promises and is forced to raise fuel prices, for instance.

"If they stick to their promises, the chances of which are low, the market could stay at these levels but if, for instance, fuel prices go up then the market should come down. But it would be a different story if the peace talks re-start."

Meanwhile, exporters are believed to be holding on to their dollar earnings in anticipation of a further depreciation of the rupee. The rupee has fallen by 6.5 percent against the dollar this year and by over 9.5 percent from the time parliament was dissolved in November 2003.

Demand for dollars eased last week as some outstanding petroleum bills had not come into the market yet. "Now the weakness of rupee has been somewhat curtailed," said a bank dealer.

Dealers said there was a belief in the foreign exchange market that huge government petroleum import bills had still not come to the market. "These unsettled petroleum bills will have to come in someday. The government is only postponing the problem."

Economists said the government has two options - either allow the rupee to move freely and its value be determined by the market without any intervention or jack up interest rates to support the local currency.

"The government may go for the second option in order to prevent the sharp depreciation of the rupee fuelling inflation," said an economist. The Central Bank has intervened heavily in the last six months and spent over $200 million to support the rupee. There has been a reduction in Central Bank foreign exchange reserves.

Analysts said the soaring price of oil and its impact on the island's balance of payments had contributed to the sharp fall in the rupee. "Oil prices have gone up to $39 a barrel this week which will not augur well for the exchange rate," said Dula Weeratunga of the Commercial Bank.

But the main reason for the rupee to weaken so sharply was believed to be the absence of the expected inflows of foreign funds from aid donors as well as through direct and portfolio investments.

"The anticipated inflow of foreign funds this year has not taken place and the market knows it," said Weeratunga. "That's why the rate went up. We still don't know whether it would come."

Although exports have improved, these proceeds were not adequate to maintain stability in the exchange rate. Some analysts said they expect the government to tinker with interest rates to support the rupee but most others said this was unlikely as the government had tried it previously and failed.

"The government tried to do this in early 2001 and failed miserably," an analyst said. He said the market perception and investor confidence in the economy or lack of it also has an effect on the currency. "If confidence can be brought back, then you don't need any additional inflows of funds."

Market perceptions were very sensitive to bomb blasts and labour strikes. The government's dollar borrowings may be used to cover its petroleum bill but this is seen only as a short-term solution.

The government sold $100 million bonds in June and plans to raise more funds abroad to minimise borrowing in the domestic market to try to take the pressure off interest rates.

"The government's main concern is to keep interest rates low - that's why it is borrowing in dollars so that its rupee borrowing requirement is somewhat controlled."

Amaratunga of Asia Capital said the depreciation of the rupee would be good for exporters as demand for their products will rise but imports will cost more and that could have a knock on effect on inflation.

Export firms like Hayleys and Haycarb could benefit from a weaker rupee as long as they are not subject to cost increases if the fall of the rupee fuels inflation.

"This means their production costs will go up." Stock brokers said they do not expect hotel stocks to be affected. There may be a temporary dip in tourist arrivals because there was a lot of negative publicity after the bomb blast, which initially was a bit misleading as it said that the peace process was at risk.

"Luckily this is the off-season and tourist arrivals had been slowing down since March - there are signs that the growth story in tourism is dying down."

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