INDA iShares MSCI India ETF

India, it seems, is destined for stubborn inflation and repo rate hike. On January 28, the Reserve Bank of India (RBI) unexpectedly hiked its repo rate by 25 bps to 8% in a bid to contain inflation. With the latest hike, India raised its repo rates by the same amount three times in the past five months (read: India ETFs After the Surprise Rate Hike).

The Indian economy has been a victim of slowing economic growth, persistent sky-high inflation, huge current account deficit, lower per-capita income and massive corruption. After a roller-coaster ride in much of 2013 on the Fed’s taper concerns and falling currency (down about 14% in 2013), concerns over the Indian market have been mounting since the beginning of this year thanks to the Fed’s decision to start scaling back its QE program.

Investors should note that India’s inflation rate at more-or-less 10% is presently one of the highest in Asia. With a possibility of continued QE trimming and flight of foreign investments from the nation, Indian currency – rupee – is likely to weaken further in the coming days and stir up another round of inflationary pressure. While a slowing in December inflation has already been recognized, rising pressure in service sectors and wage-led stress on inflation were responsible for the RBI’s anxiety.

This apprehension might have prompted RBI to go for another rate hike since its goal – and the principal agenda in its to-do list–is to pull down inflation to 6% by 2016.

Further Tightening Ahead?

Economists expect the RBI to clamp down on liquidity in the coming months as reduction of 4% inflation within two years apparently seems a tall order for India. Some economists anticipate yet another 25 bps hike in rate in early summer.  However, the RBI commented that there will be no further tightening in the near term if consumer-price inflation slackens from the high of 10% to 8% by early 2015.

However, many economists seem content with the latest RBI move which is aimed at shoring up the Indian economy over the long term and serves in ruling out inflationary threats and currency depreciation.  Still, there are economists with the opposite view as well. As per the CII, the RBI needs to focus on boosting investments and economic growth instead of curbing inflation (see Is the Worst Over for These Emerging Market ETFs?).

Concerns

Yes, this step surely comes at the cost of growth (via higher cost of borrowings) and probably corporate defaults.  As per India Ratings, the number of stressed companies will increase to 10.7% from the current 9.5% if this latest rate hike results into higher lending rates.

In fact, the situation may worsen if the RBI goes for further hikes this year by taking the number of stressed corporates to 13.1% and the amount of stressed debt to 16.5%. With the World Bank expecting Indian growth rate below 5% – a 10-year low – for the financial year 2013–2014, the recent hike is upsetting.

Market and ETF Impact

As one can imagine, this rate hike should give a much-needed boost to the Indian rupee, helping to stop its fall. With India having a huge oil import bill, a rate hike should be beneficial on this front. However, the move definitely caused a slump in the Indian equities on fears of slowing growth that resulted in losses in most of the Indian ETFs.

WisdomTree India Earnings Fund (EPI) lost 1.61% at the close on January 29, iShares MSCI India (INDA) shed 1.91%, iShares India 50 ETF (INDY) slumped 2.25%, PowerShares India (PIN) dropped 2.20%, EGShares India Infrastructure ETF (INXX) fell 1.41% and EGShares India Consumer ETF (INCO) was down 2.72%. Notably, EPI is by far the largest ETF in terms of asset base and also the most liquid fund tracking Indian equities (read: Two India ETFs Leading Emerging Markets Higher).

Rate Hike a Key Tool to Support Currency

India is not the only country taking the rate hike route; the move has also been taken by a number of other emerging market central banks in recent times to support their struggling currencies against the dollar. Turkey was among such nations (read: Indonesia ETFs Surge on Surprise Rate Hike).

Alongside with India, Turkey also raised its overnight lending rate sharply on January 28 from 7.75% to 12%, one week repo-rate from 4.5% to 10% and overnight borrowing rate from 3.5% to 8%. Soon after the announcement, Turkish currency lira went rallying and gained as much as 3%.  

Bottom Line

While a rate hike might help in boosting foreign investors’ confidence in the emerging markets, especially in the current environment when currency devaluation is a large factor, the growth picture becomes feeble. Also, investors should note that food and fuel inflation has a high allocation in the Indian CPI.

Thus it is a bit doubtful as to how far this rate hike will help in bringing down the overall inflation as the rate hike will largely and directly bother industrial sectors and indirectly impact sectors like food. A rate hike might come as a blow to the Indian manufacturing sector at a time when the sector is struggling with lower output.

Having said this, we would also like to remind investors that even after a round of rate hikes, India’s real interest rate still remains low. Also, the GDP growth outlook remains brighter than many fast-growing developed markets. Thus, India ETFs could be worth a closer look by risk-tolerant emerging market ETF investors at this time.

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WISDMTR-IN EARN (EPI): ETF Research Reports
 
EGS-INDIA CNSMR (INCO): ETF Research Reports
 
ISHARS-M INDIA (INDA): ETF Research Reports
 
ISHARS-SP INDIA (INDY): ETF Research Reports
 
EMERG-GS IIIIF (INXX): ETF Research Reports
 
PWRSH-INDIA POR (PIN): ETF Research Reports
 
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