India’s Unexpected Interest Rate Rise ‘Sign of Things to Come’

March 20 (Bloomberg) -- India’s central bank will probably raise interest rates again next month as the first increase in two years is only the initial step in the battle against inflation, BNP Paribas SA and Standard Chartered Plc said.

The Reserve Bank of India yesterday increased the benchmark reverse repurchase rate to 3.5 percent from a record-low 3.25 percent and the repurchase rate to 5 percent from 4.75 percent, saying containing inflation has become “imperative.”

Governor Duvvuri Subbarao’s move comes after Australia and Malaysia increased rates this month, while Norway and Israel did so at the end of last year as the global economy’s recovery from the worst recession since World War II gathers pace. The World Bank indicated this week that China should also act to help contain the risk of a property bubble.

“This is just a sign of things to come,” said Manoj Rane, treasurer at BNP Paribas in Mumbai. “A 25 basis-point increase doesn’t get you there but it sets the course” to contain inflation.

Lagging behind India are central banks in the Group of Seven economies with the Federal Reserve and European Central Bank among those waiting for evidence of a more concrete recovery before they unwind record low borrowing costs. Canada may be the first G-7 central bank to shift after data showed its core inflation rate unexpectedly accelerated last month.

Stocks Declined

Stocks in the U.S. declined after the decision, a month before the bank’s scheduled monetary policy meeting. Subbarao moved after India’s industrial production gained 16.7 percent in January following a 17.6 percent increase in December from a year earlier, the fastest pace since at least 1994, according to Bloomberg data. The wholesale-price inflation rate touched 9.89 percent in February, according to the commerce ministry.

“We see this as the first of several policy rate increases as the Reserve Bank of India realigns policy rates to high inflation,” said Sanjeev Prasad, executive director at Kotak Securities Ltd. Prasad, India’s top-ranked analyst in the past four years according to Asia Money polls, expects the central bank to raise interest rates by 2 percentage points in the fiscal year starting April 1.

As inflation accelerated, the difference between the overnight money-market rate and the one-year swap rate, a measure of expectations for changes in borrowing costs, surged almost six-fold this fiscal year. The spread averaged 1.59 percentage points this month, compared with 27 basis points in April 2009, when the fiscal year began. A basis point is 0.01 of a percentage point.

Doubled Holdings

Foreigners more than doubled holdings of Indian debt this fiscal year, raising total ownership to an all-time high $11.2 billion on March 18, to benefit from the rising yields on the nation’s assets. Outstanding overseas investment in stocks also climbed to a record $76 billion on the same day.

“It’s a positive step for all financial markets because it shows policy makers’ resolve to tackle the inflation problem in a timely manner,” said Arvind Sampath, the Mumbai-based head of interest-rate trading at Standard Chartered. “The measures will help subdue inflationary expectations, which is good for the economy as a whole.”

Benchmark 10-year bond yields have added 24 basis points this year, after rising by a record 2.3 percentage points in 2009 as investors braced for faster inflation and higher policy rates. India’s benchmark share index has rallied 95 percent and the rupee has gained 10 percent in the past year.

Currency option prices signal investors are the most optimistic in 21 months that rising asset yields and quickening economic growth will bolster the rupee. One-month implied volatility, a measure of expectations for rupee price movements, touched 7.4 percent, the lowest level since June 2008, on March 18, data compiled by Bloomberg show. The gauge of expected currency swings is quoted by traders as part of options prices.

Inflationary Pressures

The central bank yesterday said inflationary pressures have “accentuated” and have been “spilling over to the wider inflationary process” and pointed to the latest industrial production data to show “revival of private demand.”

India’s passenger car sales gained in February to a record amid rising incomes in the world’s second-most populous nation. The demand is encouraging Ford Motor Co. and Volkswagen AG to build plants and unveil new models in the South Asian nation.

India’s $1.2 trillion economy, Asia’s biggest after Japan and China, may expand 8.2 percent in the next fiscal year, compared with 7.2 percent in the year to March 31, the Finance Ministry said in February.

Inflation has returned to Asia as growth accelerates amid the global economic recovery. Consumer prices in China rose to a 16-month high of 2.7 percent in February from a year earlier as industrial production grew 20.7 percent in the first two months of 2010, the most in more than five years. Factory output in Malaysia rose 12.7 percent in January.

Inflation is politically sensitive in a country such as India, where the World Bank estimates three-quarters of the nation’s 1.2 billion people live on less than $2 a day. Opposition parties led by the Bharatiya Janata Party repeatedly stalled proceedings in parliament this month, accusing Prime Minister Manmohan Singh’s government of being anti-poor and failing to curb prices.