JP Morgan sees interest rates rising 150 bps

The Reserve Bank of India is likely to hike interest rates gradually by up to 150 basis points over 12-18 months in keeping with the apparent reversal in the economic cycle to a recovery mode, J P Morgan's strategist, Siddharth Mathur, said.

"Given the momentum in the domestic industry, given developments in credit, given developments in inflationary environment, and also taking into account what is happening in the rest of the world, there is a strong probability that we are in for 12-18 months of sustained upward pressure on interest rates," Mathur said.

Gross domestic product (GDP) and industrial production numbers clearly give an indication that the economy is in a recovery mode, Mathur said.

India's GDP in the first quarter of 2004-05 (April-March) rose to 7.4 per cent from 5.3 per cent a year ago, and above an expected 7 per cent.

In the first four months of 2004-05, industrial output grew 7.8 per cent versus 5.9 per cent a year ago.

Mathur said the Reserve Bank of India's repo rate would rise to 5.50-6.00 per cent eventually.

To begin with, in the mid-term review of the 2004-05 annual policy on October 26, the central bank is likely to hike the repo rate 25 basis points.

This could be followed by another 25 bps hike early next year.

"We think repo rate needs to go up by 100-125 basis points over a period of time," he said.

"It's a judgment call whether that period is 12, 15, or 18 months. But certainly in the next 12-18 months a 100-150 basis points hike in repo should be expected."

Mathur said a delayed monetary tightening would add to inflationary pressures. Also, impact of such tightening would come with a lag.

On the other hand, an immediate hike in rates would hamper growth, Mathur said, since borrowing would become expensive.

"In our estimate, a 25-basis-point hike, to begin with, gives RBI some flexibility...that it makes credit not all that expensive."

It may be noted that the US Federal Reserve had last month hiked interest rates by 25 bps, and had said it saw "roughly equal" upside and downside risks to sustainable growth and price stability in that country.

Inflation: The impression that inflation in India currently is caused entirely because of high oil prices is incorrect, said Mathur.

Oil contributes only 14 per cent to the index of inflation, he said.

Manufacturing price inflation, which does not get impacted the same way as oil price inflation, is at a high level of 7.4 per cent, Mathur pointed out.

"Even accounting for volatile components of inflation such as oil and food products, inflation is still running at 7 per cent and is accelerating. This is an area of concern. Let us not be lulled into complacency that inflation is high because of oil."

The general level of inflation across the economy is picking up. It's around 7 per cent and is accelerating. That remains a concern, Mathur said. At 7.80 per cent, the Wholesale Price Index inflation for the week to September 18 was in line with market expectations. In August, it had touched a 40-month high of 8.33 per cent.

There is imported inflation but the fact it is translating into domestic inflation indicates that demand is healthy, Mathur said.

Nevertheless, the central bank is likely to revise its inflation estimate to 6.00-6.50 per cent in the policy review, with an upward bias, from around 5 per cent projected earlier this year.

Oil slip: Mathur said a hike in domestic fuel prices "" a sharp one "" appears imminent following the soaring crude prices in global markets. Crude oil prices are flirting with an all-time high of US $50.47 a barrel on the New York Mercantile Exchange.

"The price pressure on (Indian) oil companies is quite substantial to hike prices. If international prices do not come down, then there is only so much time that they will bear the pressure," Mathur said.

"Our forecast is $42 (a barrel) for the quarter (end-December). We don't see it going below $40 for the next three quarters."

Forex reserves: Over the long-term, given its current stage of development, India will continue to need capital. The RBI should not undertake steps that cause either a capital outflow or the capital coming in India to slow down on a sustained basis.

"We cannot afford a situation where capital stops coming in and the currency collapses," he said.

Mathur dismissed a view held by some that the central bank was supporting the rupee by trimming the reserves to contain inflation.

"The amount of adjustment required in the value of the rupee to meaningfully reduce inflation is substantial and carries with it the risks that economic activity will suffer," Mathur said.

Foreign exchange reserves as on September 24 were $118.769 billion, up by $28.250 billion from a year ago.

The RBI does dampen volatility but does not influence the trend in the rupee's exchange rate.

"In the short-term, RBI is stabilising factor," he said.

CRR hike: The recent two-stage hike in banks' cash reserve ratio totaling 50 bps was not entirely a surprise because the move was in the same direction as many in the market had expected the RBI to take.

"We expect the RBI to recognise that the economic cycle has turned and that there is risks of inflation, which are now manifesting themselves and take appropriate action to control those risks.

"Taking appropriate measures means either raise the price of money outright or control the quantity of money, or both."

He said the CRR hike was a signal that the RBI recognises that the economic cycle had reversed. CRR hike was a signal that RBI was willing to take action that was in keeping with the risks that the economic cycle is moving into, he said.