Indian rate hike sets the scene for the rest of Asia

SO FAR this year, the markets have been concentrating on the prospect of monetary policy tightening in China and what that will mean for global recovery. But while the Asian powerhouse has been slowly tightening here and there in an effort to cool its economy down, it was India that bit the bullet and hiked rates by 25 basis points late last Friday.

The decision by the Reserve Bank of India (RBI) was made between meetings and it delivered an increase in both its benchmark repo rate to 5 per cent and its reverse repo rate, which now stands at 3.5 per cent.

While the hike was not scheduled, it did not come as much of a surprise to the markets, given the emerging inflation problem that the Indian authorities are trying to tackle. Indeed, the RBI cited in its accompanying statement recent developments in inflation – an annualised 9.9 per cent in February – as a source of growing concern and noted that anchoring inflation expectations and containing overall inflation have become imperative.

Further rate hikes are also in the offing, with analysts sceptical that one rate rise will be enough to bring inflation down to the 5-6 per cent desired by the RBI. As a result, the expectation is for another 25 basis points in April and the repo rate to hit 6 per cent by the end of the year.

The Indian rupee has been strengthening against the US dollar since early February and the rate hike should be supportive of further appreciation. The pair is currently trading at around R45.49 but the support level of 45.25 – the January low – is currently being eyed by the market. A break through here would put the September 2008 low of 45.24 in focus and a potential test of 44.

The rupee is expected to continue to strengthen and the latest hike should also attract more foreign inflows into India, which has already received $3.5bn in overseas investment since the start of this year and is expected to continue receiving investment at a similar pace.

Prompted by improved government finances, the rating agency Standard & Poor recently updated its outlook on India’s sovereign debt, which is rated at BBB-, to stable from negative. This should also encourage further capital inflows into the country. Foreign exchange traders could therefore look to short dollar-rupee using any rebounds to take out positions.

But the Indian rate hike has wider implications for the currency markets beyond the rupee. The sense of urgency in India to raise rates has sparked speculation that other Asian currencies may also start to tighten policy in the coming months. This should ultimately be supportive of emerging market currencies in the region, which will benefit from favourable interest rate differentials attracting speculative hot money into the region.

Phil McHugh, corporate dealer at Currencies Direct, says that the Indian decision has put the cat among the pigeons and that many Asian indices dropped across the board in response, although the rupee has remained largely stable in the immediate aftermath.

Emerging Asian markets have not raised interest rates for some time, but the region’s rapid recovery from the global recovery has stepped up inflationary pressures and led to a repricing of the rates outlook in a number of Asian countries. Indeed, BNP Paribas currency strategists reckon that China’s situation is not that different to India’s, leaving markets wondering when China will increase its rates. This will have an impact on the G10 currencies.

They say: “Asia’s inflation rates have increased sharply requiring monetary policy responses. The RBI increased rates in an emergency move on Friday, causing the Australian dollar to fall back. China is the next on the agenda to hike rates. Rate hikes dampen domestic demand and hence will work against commodities.”

However, they highlight that the impact of dampened monetary expansion in Asia on Asian currency reserve growth will be more important. “We expect currency reserve growth to decline, which in turn will reduce dollar liquidity and hence support the dollar,” they add.

Therefore, foreign exchange traders could look to go short on the dollar-rupee pair. If you are concerned about trading the rupee, you could also take out bearish positions on commodity currencies such as the Australian dollar. These currencies will struggle to make ground against the US dollar if emerging markets lose their voracious appetite for raw materials.