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Last Updated: Monday, 2 April 2007, 15:55 GMT 16:55 UK
What next for Indian interest rates?
By Sanjeev Srivastava
India editor, BBC Hindi Service

Luxury car salesroom
Car sales will be hit by rising rates

Indian stocks ended over 600 points down, nearly 5%, on Monday following fears that Asia's fourth largest economy may begin to slow down.

This comes after the country's central bank, the Reserve Bank of India, raised key interest rates in an effort to lower inflation which is at a two-year high.

Monday's stock market fall was one of the sharpest in recent months.

Investors are nervous about the future earnings of Indian corporates in an environment where rising interest rates mean the money supply will be tight and credit will be more expensive.

The biggest losers were bank stocks as investors felt that interest rate increases would impact credit growth and the banks' profitability.

Automobile, housing and property company stocks also fell.

While the central bank's decision to raise interest rates is aimed at reining in the 6.5% inflation rate and prevent the economy, which grew at a scorching 9.2 % last year, from overheating, analysts fear that the move could eventually result in the economy slowing down.

Government calm

According to Sushil Choksey , a Mumbai-based stock broker, the unexpected rate hike nearly a month before a scheduled review was due on 24 April, has come as a "negative surprise to the markets which are likely to decline further before finding stability at lower levels".

Finance Minister P Chidambaram
Finance Minister Chidambaram used to support lower interest rates

What is further worrying market analysts is that nobody seems to be sure whether interest rates have topped out for the moment or the central bank might announce another increase after a few weeks if inflation is not showing signs of coming under control.

While stock market analysts may be nervous, the government is not too perturbed.

After being a supporter of benign interest rates for the last couple of years, Finance Minister P Chidambaram, is now supporting the central bank's interest rates decision.

Until now he had strongly advocated a lower interest rate to help accelerate economic growth which would, so the argument goes, have a trickle down effect and reduce poverty.

Election factor

Some analysts believe that the governing Congress party and the finance minister are under pressure after the victory of opposition parties in two northern Indian states last month.

Inflation and rising prices of essential goods had become a major poll issue in the current round of state elections.

Indian labourer sorts onions
The growing economy has pushed prices higher

The finance minister is now keen to tame inflation at the earliest opportunity to ward off criticism that his monetary policies are responsible for the Congress party's election losses.

The party is facing state elections again this month in Uttar Pradesh - the country's most populous and politically significant state.

But some analysts see a silver lining in the interest rates going up at this juncture.

A senior economist with ABN Amro bank, Gaurav Kapur, told the BBC that the central bank's move will "lead to a segregation between real and speculative demand for funds".

This would prevent the economy from overheating and bring back a semblance of realism in the Indian markets.

Many analysts think that, from a medium to long-term perspective, what would be more healthy for the Indian economy is a growth rate slightly lower than the current nine per cent - perhaps even down to 7.5-8% - with inflation down to about 5%, rather than the present 6.5 % inflation rate with an economy which is showing signs of overheating.

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