India's Sensex under shadow of inflation

Mumbai: Mounting concerns of inflation hitting double-digits could cast a dark shadow over Indian shares this week as investors brace for an increase in prices of petrol and diesel - a move that will fire up price pressures already bursting at the seams.

"A fuel price hike is inevitable," Petroleum Secretary M.S. Srinivasan said on Friday as the cabinet began discussions to soften the blow from soaring world prices of oil, including a cut in import levies and other taxes.

His comments came a week after Reserve Bank of India Governor Y.V. Reddy said inflation data was underestimated due to the inadequate pass through of oil prices, and this posed a serious challenge to policy.

India has raised retail prices of petrol and diesel only once in the past two years, by a measly average of four per cent, while global prices have jumped by more than half. For a country that imports 70 per cent of its annual oil requirement this was flirting with trouble as world prices climbed to record highs above $135 a barrel.

"The government is under tremendous pressure to bite the bullet and raise fuel prices," said Biju Dominic, who advises retail clients in Mumbai.

The surge in world oil prices has pushed large state-run refiners like Indian Oil Corp, Bharat Petro-leum Corp and Hindustan Petroleum Corp that are compelled to sell retail fuel at low prices to the brink, triggering concern they would not be able to pay for imports and may resort to rationing of fuel.

"We need to take immediate steps to save oil companies and I have discussed the issue with the prime minister last night," Oil Minister Murli Deora said on Friday.

But higher fuel costs would cause unease for stock investors who are already grappling with slowing corporate earnings and a drop in consumer spending.

"It will have a cascading effect on inflation and lead to tighter monetary policy, including a possible hike in interest rates," Dominic said.

The Sensex fell 4.5 per cent last week to 16,649.64, its lowest close in over five weeks and indicating more pain ahead.

"The outlook is grim," said equity trader Rasesh Shah. "We're urging investors to stay in cash until the market stabilises."

Annual inflation stayed at its highest in more than 3-1/2 years in the week ended May 10 at around 7.8 per cent, but analysts said the preliminary data would be sharply revised upwards later as the government has been doing for the past many weeks.

On Friday, the government said inflation for the week ended March 15 was 8.02 per cent - the highest since September 2004 - and well above the 6.68 per cent preliminary figure released earlier.

Dominic said a similar revision to the latest data could put it close to 10 per cent, and a fuel price increase would propel it further higher.

Not acceptable

The central bank, which has been saying the current rate of inflation is not acceptable and need to be brought down to 5.5 per cent, will have little option but to further tighten policy, he said.

Last week, Pakistan abruptly raised the main interest rate by 1.5 percentage points to 12 per cent, its highest in more than six years. The move sent the Karachi 100-share index tumbling more than four per cent on Friday.

"India could follow Pakistan's lead and raise interest rates," Shah said, adding foreign exchange dealers had begun factoring in this possibility.

The Indian rupee pulled back on Friday from 13-month lows to end at 42.70 per dollar after falling as low as 43.3 a day earlier, largely on hopes an interest rate increase would boost the rupee's arbitrage versus the dollar.

Still, the rupee ended down 0.5 per cent on the week, stretching a losing streak into a fifth week and taking losses to 7.7 per cent so far this year. High global oil prices and a widening India's trade deficit are expected to keep the rupee under pressure.

Goldman Sachs cut its forecasts for the rupee, predicting a 3.2 per cent drop in the next six months. "The recent large move up in the dollar has caught us by surprise and appears to be driven by the run-up in oil prices," analysts Tushar Poddar and Pranjul Bhandari wrote in a note.

"The rupee will continue to weaken," they said, lowering their three-month, six-month and one-year forecasts for the rupee to 43.9, 44.1 and 42.2 from earlier estimates of 41, 40.3 and 38.9, respectively. The broad measure of trade that includes investment flows will widen to 3.5 per cent of gross domestic product in 2008-09 from 1.5 per cent the previous year, the analysts said.

- The writer is a journalist based in India.