Rising greenback could make you see red

Returns from the Indian market to weaken as the dollar gets stronger against major currencies.

For investors in the Indian stock market, the rising dollar is a cause of worry. With growth concerns across the world, foreign institutional investors are moving their money to safe havens. And in most cases, the safe haven happens to be the dollar.

The US Federal Reserve launched the QE2, its $600-billion bond buying programme, in November 2010 to prop up the ailing economy. With the programme expected to end in June, the liquidity conditions will become tighter. Fund managers, as a result, are already busy pruning their risky assets, including investments in Indian and other emerging market equities.

“Around 40 per cent of the money that enters India is hedge fund or hot money, which is interest rate and exchange rate-sensitive. There has been some flight of capital in anticipation of the QE2 ending,” said Saurabh Mukherjea, head of equities at Ambit Capital.

Besides the QE2 ending, sovereign debt woes emanating from Greece have also supported the dollar’s up move. Citigroup’s Hong Kong-based analyst Kelly Kwok said the dollar strengthened because whenever investors are risk averse, they sell other assets and buy the dollar.

As a result of these events, emerging market equities posted their first weekly loss last week (ended May 18) after seven consecutive weeks of inflows. According to an equity strategy report by Citi, emerging markets saw outflows of $1.6 billion for the week ended May 18, as investors sought to avoid risk.

No wonder then that the dollar and the Sensex’s inverse relationship has become very stark in the past three weeks. The Dollar Index, which measures the performance of the US dollar against the basket of six major currencies, has bounced from a recent low of 72.93 (April 29) to 75.62.

During the same period, the Indian benchmark Sensex has fallen 6 per cent. Foreign institutional investors (FIIs) have sold equities worth $1.74 billion (Rs 7,791 crore) in the Indian markets in May, according to data from the Securities & Exchange Board of India.

However, experts believe there are no reasons for long-term investors to panic. While the Indian markets have been weak because of the underlying fundamental reasons of high inflation and monetary tightening, which may dent the country’s growth prospects, Mukherjea said, “the price movements in the market in the last four-five months have not been so significant for patient long-term money to either consider a major exit or entry. The four-five per cent market movement that we have seen is of interest to hedge funds that are interested in short-term flip trades.”

The good news for investors is that a strong dollar is likely to be a temporary phase. Traders are shunning riskier assets like equities and are putting money in the greenback because of the Greek debt restructuring woes, concerns over global growth and weakness in commodities, according to Moses Harding, Head – Global Markets Group, IndusInd Bank.

The euro, which has the highest weight in the dollar index, has slipped 5 per cent against the greenback in the past month on worries the euro zone may not be able to raise interest rates ahead of the US, said Harding.

N Subramaniam, forex consultant at Pinnacle Forex, said, “At near zero interest rates, nobody wanted the dollar, but if Ben Bernanke ends the stimulus package and raises interest rates, it will strengthen. The short on the dollar and long on equities and commodities trade, which has been very prominent for the last two years, is unwinding.”

Once the QE2 ends, the cheap money flowing across different asset classes will dry up. Analysts say long-term funds have not been coming into India for the past few months, which may be the case in the near future unless fundamental factors improve.

But, how far will the dollar rise? Kwok says the dollar’s strength is only temporary because fundamentally the US economy continues to remain weak against the emerging economies. Harding expects the Dollar Index to surge to the 79 levels in the near term before cooling off.