India Signals Further Rate Moves to Fight Inflation

By Cherian Thomas and Anil Varma

June 25 (Bloomberg) -- India's central bank signaled it will keep raising borrowing costs after unexpectedly lifting interest rates for the second time in two weeks and telling lenders to keep more cash in reserve. Bonds and stocks tumbled.

The Reserve Bank of India increased the repurchase rate by 0.5 percentage point late yesterday to 8.5 percent, the biggest move since 2000, and adjusted the cash-reserve ratio by a similar margin to 8.75 percent. A ``heightened vigil'' was needed to anchor inflation expectations, the central bank said in a faxed statement.

Governor Yaga Venugopal Reddy has been caught wrong-footed in setting policy by the surge in crude-oil prices that pushed inflation to a 13-year high. Higher rates are needed to convince investors that officials won't let inflation erode returns on stocks and the currency, which have suffered their worst start to the year in at least a quarter-century.

``The RBI is trying to catch up with the curve finally,'' said Edwin Gutierrez, who manages $5.5 billion in emerging- market debt in London at Aberdeen Asset Management. ``The move underscores the fact that they blew their opportunity to do this earlier.''


Yesterday's decision came a month before the next monetary policy meeting, scheduled for July 29, as the impact of the first increase in gasoline prices in more than a year pushed inflation to double Reddy's target. Higher fuel prices accounted for most of the 11.05 percent wholesale rate of inflation during the first week of June.

First Step

The central bank may raise interest rates by another 25 basis points in the July 29 policy meeting, economists at JPMorgan Chase & Co. said, while analysts at Citigroup Inc. expect borrowing costs to be increased by as much as 50 basis points without giving a time frame.

``If inflation indicators don't start to come down in the next two or three months, the RBI has more tricks up its sleeve,'' said Jyoti Narasimhan, research director for India at Global Insight Inc. in Lexington, Massachusetts. ``This is more of a first step than a last step.''

The government needs a stronger rupee to lower import costs and aid in curbing prices. The rupee has fallen 8.2 percent this year, making India the only one of the so-called BRIC nations including Brazil, China and Russia that has a weaker currency. The rupee gained 0.2 percent to 42.87 per dollar at 10:55 a.m.

``The policy stance adopted by the RBI should boost the confidence of investors, both domestic and foreign, and augur well for economic growth,'' the finance ministry said in a statement in New Delhi today. ``The objective of the RBI is to moderate and manage aggregate demand.''

Spooked Investors

Overseas investors, spooked by accelerating inflation, have dumped $6.2 billion more of Indian shares than they bought this year, causing a 30 percent decline in the Sensitive index.

India's 10-year bond yields climbed to as much as 8.86 percent, the highest since October 2001 in Mumbai. The benchmark Sensitive stock index fell 1 percent to 13,967.8, after earlier declining to the lowest in 13 months.

Last week's spurt in inflation in India was driven by the first increase in retail prices of gasoline and diesel this year. India joined China, Indonesia, Malaysia and Sri Lanka as a near doubling of oil prices pushed up costs and eroded profits of refiners such as Indian Oil Corp.

`Inflation Shocker'

``The latest inflation reading was a shocker because of the nature of the oil prices passthrough,'' said S. Ananthanarayan, chief bond trader at Kotak Mahindra Bank Ltd., a Mumbai-based primary dealer that underwrites government debt sales. ``They probably felt all the measures they've taken so far have been inadequate, and now they're playing catch-up.''

Higher inflation may further hurt consumer demand and threatens to derail India's record 8.8 percent annual economic growth since 2003, the fastest after China among the world's major economies.

The inflation rate has almost tripled this year, eroding the popularity of Prime Minister Manmohan Singh's ruling Congress Party, which lost ground in nine of 11 state elections since January 2007. Congress will also face criticism from its communist allies today over a nuclear accord with the U.S. that threatens its four-year hold on power.

``The Manmohan Singh government is squarely responsible for this dismal situation,'' the Communist Party of India (Marxist), the biggest ally of the government, said on June 20. ``It cannot escape by blaming global inflation.''

`Line of Defense'

Finance Secretary D. Subbarao said June 21 that monetary policy is the ``first line of defense'' as the government tries to keep food and fuel affordable before elections. More than half of India's 1.1 billion people live on less than $2 a day.

Before yesterday's move, Reddy had raised the repurchase rate eight times in the past 2 1/2 years and increased the cash reserve ratio seven times since December 2006 to slow money supply and cool inflation.

The central bank's reserve ratio will be increased to 8.5 percent from the fortnight commencing July 5 and raised to 8.75 percent in the two weeks starting July 19, according to yesterday's statement.

India has supported monetary policy steps with tax cuts to ease prices. On June 4 the government scrapped taxes on imports of crude oil and reduced duties on other fuel products, forgoing $5.3 billion of revenue to cushion consumers from high fuel costs.

``It'll be difficult for them to hike just once or twice and then step back,'' said Paresh Upadhyaya, who helps oversee about $50 billion in currency assets, including in emerging markets, at Putnam Investments in Boston. ``This is going to be a clear tightening cycle, and I expect more to come in the next 12 months.''

To contact the reporter on this story: Cherian Thomas in New Delhi at cthomas1@bloomberg.net