RBI rate hike will not stem outflows, leaving central bank in a bind

MUMBAI: India's first rate hike in four years is unlikely to slow or reverse record high capital outflows, leaving the central bank battling the vicious cycle of a weakening currency and higher inflation in a hostile global environment.

The modest hike of 25 basis points, even with signs of more to come, will do little to curb pressure on the rupee, while expectations for a weaker currency and a sharp jump in hedging costs are set to weigh on returns from both debt and equities.

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"It's a good start. But is it enough? Probably not," said Carl Vermassen, a portfolio manager with the emerging markets fixed income team at Zurich-based Vontobel.

"The central bank should have been more hawkish to alleviate the pressure on the currency."

Traders and analysts have said firmer language by the central bank on future hikes and the rupee would have helped the currency, as opposed to describing the hike as a "milder form of tightening", where increases are not pre-determined.

Already one of Asia's worst-performing currencies this year with a fall of 7%, the rupee declined after Wednesday's RBI move to within striking distance of its all-time low of 96.96 against the dollar.

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More worrying for the currency, however, is the soaring cost of protecting against further weakness. One-year hedging costs surged after the decision to stand up more than 60 basis points this week.

Foreign investors have pulled a record $30 billion from Indian equities this year, while debt flows have turned negative since the beginning of September.

"The hike may slow outflows at the margin by reinforcing policy credibility, but it is unlikely to reverse them on its own," said Sat Dhura, portfolio manager at Janus Henderson Investors, which manages $500 billion in assets.

"The direction of flows will continue to depend more on US yields, the dollar, oil prices, earnings and valuations than on a single 25-basis-point move," said Dhura, adding that the hike had not prompted his firm to turn into a buyer of Indian stocks.

NARROWED DIFFERENTIALS DRAG BONDS

A key concern for investors has been the shrinking interest-rate gap between India and the United States.

The premium offered by India's 10-year government bond over equivalent U.S. Treasury and German Bund yields has fallen to its lowest since 2004 and 2009, respectively.

India's differential with US policy rates is at a record low.

"Very tight differentials could consistently pressure the exchange rate which, in turn, would have implications for the domestic inflation outlook," Sajjid Chinoy, chief India economist at J.P. Morgan, said in a note before the RBI hike.

With the RBI focused on domestic conditions to determine monetary policy under its inflation targeting framework, the rupee could remain the "shock absorber", Chinoy said.

"Lack of visibility of stability on the Indian rupee and a higher cost of hedging will mean that Indian equity assets will continue to be relatively less attractive," said Ajay Marwaha, head of fixed income at Nuvama Group, a wealth manager with global operations.

For debt investors, higher global bond yields and a narrow rate differential with the US remain a concern, Marwaha said.

DOMESTIC VS GLOBAL FACTORS

Economists broadly see the RBI action as appropriate for India's domestic mix of growth and inflation, with price pressures still driven by energy supply disruptions and higher food costs.

Inflation is running above the central bank's target of 4% but remains within its tolerance band of 2% to 6%.

The RBI justified its hike on the grounds that the second-round impact of higher food and fuel prices was still modest.

"While there is some evidence of elevated inflation expectations and generalisation of inflation, there are limited signs of supply side pressures getting embedded in pricing behaviour," it said on Wednesday.

Even so, the central bank may need to hike rates by 50 basis points in December, said Soumya Kanti Ghosh, chief economist at State Bank of India, who also saw merit in raising the rarely used marginal standing facility rate.

Raising the MSF, an overnight borrowing window for banks, could push money-market rates higher, improving the carry on rupee assets and making Indian debt more attractive to foreign investors.

Ghosh also favours a cut in taxes for long-term foreign equity investors, after this year's tax cut on overseas investors in debt.

The RBI may ultimately be forced to tighten more than domestic conditions alone would warrant, Dhura said, adding:

"Higher developed-market yields and a stronger dollar constrain emerging-market central banks through currency weakness, imported inflation and capital outflows, even where domestic conditions might otherwise justify easier policy."

(Reporting by Ira Dugal, Jaspreet Kalra and Nimesh Vora; Editing by Clarence Fernandez)