Rising inflation may goad the Reserve Bank of India into hiking the repo rate, or a key lending rate, as the central bank acts to curb inflationary expectations

Mark to market | Manas Chakravarty and Mobis Philipose

Aspectre is haunting the markets, the spectre of higher interest rates. On Wednesday, with the government deciding to raise fuel prices by 10%, the stock market slumped while bond yields jumped.

Did the stock market over-react? After all, a hike in fuel prices was widely anticipated. Essentially, all that the hike in fuel prices and the cut in duties do is to re-allocate the burden of high oil prices. Before the rate hike, it was the oil companies, both upstream and downstream, that were bearing the brunt of the rise in crude prices. After the hike, consumers and the government will now bear a larger share. Companies, too, will be hit, to the extent that they have to pay higher freight and input costs.

(CASHING IN) Will the hike in prices slow demand growth? Well, there have been several fuel price hikes in the past and they have had little impact on demand. The quantum of the price rise is also not large enough to have shock value. The difference this time is that growth is already slowing, so the impact of the fuel price hike will be greater. That goes for inflation tooits going to go up from the already high levels.

The real worry, however, is that rising inflation may goad the Reserve Bank of India into hiking the repo rate, or a key lending rate, as the central bank acts to curb inflationary expectations. A. Prasanna, senior economist with ICICI Securities, says RBI may be making the same mistake now as central banks did in the 1970s, when they continued to maintain a loose monetary policy stance in the face of an oil price shock. Money supply growth at 22% year-on-year is well above nominal gross domestic product (GDP) growth and real interest rates are in negative territory.

Other economists make the same point. Gaurav Kapur, senior economist with ABN Amro Bank, points out that while the central bank has relaxed its policy on external commercial borrowings to ensure investment demand remains robust, it would do well to reduce consumption demand, which is the only way inflation can be contained. He argues that the latest data from the Purchasing Managers Index show that companies have been passing on input price hikes to customers, which means that they have pricing power. Only hiking interest rates will reduce consumption demand. Its this worry of higher interest rates that has spooked the markets. Bond yields have moved up to a one-month high as the debt markets worry about whether the central bank will move to hike interest rates.

In any case, the duty cuts mean a higher fiscal deficit, with HSBCs Manas Paul estimating that it would add another 0.5% of GDP to the deficit. The higher borrowing requirement would add to the upward pressure on interest rates.

For public sector oil marketing companies, which have been bleeding because of soaring crude prices, the price hike will come as a relief. Whats more, customs duty on crude has been scrapped from 5% and that reduces under-recoveries by an equally large amount. Still, under-recoveries continue to be high and these companies will be hoping that crude prices come off their highs soon. These stocks had rallied in anticipation prior to the fuel price hike and gave up some of those gains on the announcement, although the dual package of the duty cut and the price hike was more than what the market had estimated.

Among the worse hit will be sectors such as cement, that are sensitive to road freight costs. Within the sector, companies such as Ultra Tech Cement Ltd and Grasim Ltd, which use road transport to a larger extent, will be hit more, says an analyst tracking the sector.

Shares of Maruti Suzuki India Ltd came off by 4.6% on Wednesday on fears that higher fuel costs will impact sales of small cars, since first-time car owners, who include those upgrade from motorcycles, will have to rethink because of higher running costs.

But, the revival in sales of passenger cars in the past two months implies that the impact may not be much since underlying demand has been steady.

But, companies in sectors where the government has arm-twisted them into not increasing prices despite rising input costs, such as steel, may be affected.

For the broader stock market, the sell-off has been sharp. The National Stock Exchanges Nifty index was at around 4,700 just before news of the hike came. It fell by 2.5% to 4,581 by the end of the days trading session.

Oil and Natural Gas Corp. Ltd, whose share of the subsidy burden will come down, was the only gainer among Nifty stocks. The fuel price hike will add some more to the worries on inflation, although sectors such as consumer goods, which are currently enjoying pricing power, should be easily able to pass on the higher costs.

Its important to note, however, that even some IT and telecom shares, which dont get impacted at all from the fuel price hike, fell by about 3%. The overall sentiment seems to be negative, with the fuel price hike only making matters worse.