(Bloomberg) An emerging-market selloff that’s hit India hard presents its central bank with a dilemma: hold interest rates steady to keep the economy motoring or follow the example of the Philippines and Indonesia by raising them to stem market pressure.

COMMERCIAL BREAK
SCROLL TO CONTINUE READING

The rupee has dropped about 5 percent against the dollar this year and yields have spiked on government and corporate bonds. While those moves would argue for a rate increase, most economists aren’t convinced it will come on Wednesday. Of the 41 surveyed by Bloomberg, 27 predict the monetary policy panel will leave the benchmark repurchase rate at 6 percent.

For the inflation-targeting board -- which last met in April before the latest bout of emerging-market pressure forced Argentina, Turkey and Indonesia to raise borrowing costs -- rising prices are also a factor. Inflation accelerated to 4.6 percent in April, above the central bank’s medium-term goal of 4 percent.

“The heat is now on the RBI to tighten monetary policy, not only due to the risks to domestic inflation but also due to the changing global financial landscape,” said Indranil Pan, chief economist at IDFC Bank Ltd. in Mumbai.

The two rate hikes by Indonesia’s central bank are fanning expectations the RBI will make a similar move, he said. Both economies have a heavy reliance on foreign inflows that makes them vulnerable to rising U.S. interest rates.

The Federal Reserve needs to slow the pace at which it plans to shrink its balance sheet to help emerging economies overcome the recent market turmoil, RBI Governor Urjit Patel, wrote in an article in the Financial Times published June 3.

What’s keeping the RBI from hiking is the nascent economic recovery and an uncertain inflation outlook. Growth is only now strengthening from the adverse impact of the 2016 ban on high-value currency notes intended to combat corruption and the chaotic implementation of a consumption tax last year.

Oil Surge
The inflation outlook is also uncertain given the surge in oil prices. The RBI forecast in April that inflation would tail off in the second half of the financial year, but Brent crude prices climbed to about $80 a barrel in late May, driving up fuel costs in the world’s third-largest oil importer.

While policy makers debate their next move, financial markets are already pricing in higher central bank borrowing costs. The yield on 10-year government bonds climbed to a three-year high of 7.94 percent in May, while similar-maturity rates on top-rated corporate bonds surged to 8.70 percent Monday, the highest since November 2014.

Ten-year yields fell one basis point Tuesday to 7.87 percent, while the rupee weakened 0.1% percent to 67. 1575 per dollar as of 10:25 a.m. in Mumbai.

RBI policy makers aren’t immune to the signals from the financial markets. The bond market is “telling us that we have fallen behind the curve,” Michael Patra, one of the six officials on the rate-setting panel, said at the February meeting, according to minutes published later than month.

“Bond yields and short-term borrowing costs have moved up and one of the MPC members is on record saying that fixed-income markets are sending signals to policy makers,” said Priyanka Kishore, head of India and Southeast Asia economics at Oxford Economics Ltd. in Singapore. “The MPC risks falling behind the curve if they keep kicking the can down the road.”

The bond market is pricing in 50 to 75 basis points of increases in interest rates over the course of the fiscal year to March 2019, swaps show.

With the spreads between market rates and the central bank’s policy benchmark widening, the risk is the central bank may have to tighten at a faster pace later this year if inflation accelerates. Increasing policy uncertainty may weigh further on bonds.

Watch this Zee Business video

article first appeared in Bloomberg.com, and is published by special arrangement.)