As many Europe-bound Indians and tourists trapped in Mumbai or New Delhi have spent the week mulling over increasingly exotic routes back home (Moscow? Rome? Then a car to Scandinavia?), the Reserve Bank of India raised interest rates for the second time in as many months.

As a result, banks’ cash reserve ratio has been raised to 6%, the key repo rate is now at 5.25% and the reverse repo at 3.75%. Yet, with consumer inflation running at close to 10% (and food prices at double that rate), the higher interest rates will still trail the runaway price indices. Indeed, of all the major emerging markets, India is facing the most serious inflation challenge. Its currency peaked in February 2009, but has since lost 15%. Meanwhile, real exchange rates of Brazil, Russia and Indonesia have continued to appreciate, which partly helped these economies stem imported inflation. Indian economy is also radically different from China’s. While the northern neighbor continues to stun observers with its addiction to serial overcapacity generation, Indian demand is chasing insufficient supply of goods, repeatedly triggering administrative measures which negatively impact the country’s trade account.

Such trade wobbles contribute to the fact that, year on year, India’s foreign reserve accumulation has grown by only 5.5% – a pale shadow of the double digit growth in other BRICs and in Newly Industrialized Countries (Taiwan, Korea, Hong Kong and Singapore). These two groupings added 22% and 26% of reserves, respectively. In this context, India’s purchase of 200t of gold, at $1040/oz last September appears a highly significant – if unprecedented – move in the overall reserve management strategy.

New Delhi says it targets 5.5% inflation, but the increase in food prices has already caused political unease, with BJP opposition party trying to exploit the mounting dissatisfaction.

So far this year gold has been range-bound in Rupee terms – testing 52000/oz on three occasions and enjoying a solid support at around 49500/oz. Contrary to uncovered interest parity theory, in practice the exchange rate does not strengthen when interest rates are low to compensate for expected depreciation. But given that India’s capital account is only partly open, nor is the 25bp increase in the main lending rate likely to generate a stampede of foreign capital into the Rupee. In other words, India’s gold buyers may not get a fillip from a stronger Rupee ahead of the upcoming Askhaya Tritya festival.

Askhaya Tritya falls on May 16. According to Indian astrologists’ Mahurata theory any important activity commenced on this date will benefit from its auspicious timing. Hindus consider gold purchase on this occasion as the key to lasting prosperity. No surprisingly, the festival is recognized to be the last significant gold-buying date in the country prior to the monsoon season. One of India’s private banks alluded this week that it expected a 30% increase in purchase of gold coins, compared to last year’s 440kg. This is a bold assumption, given that in Rupee terms gold is hovering some 15% above last year’s prices. But India’s notorious price elasticity could be affected by stronger real income growth and further distorted by money illusion generated by the fast-accelerating inflation rate. This last factor is most relevant in India’s cities. In fact, urban inflation index in India has doubled since last year’s Akshaya Tritya.

All this goes a long way to explain the improving sentiment in this 480tpa gold market. India’s inflation fears feed not only increased interest in gold, but also in silver. Western investors, at least outside Australia and Canada, have been trapped in the recurrent deflationary jitters caused by the seemingly eternal Greece debt fears, slow recovery in service sectors, sluggish investment growth, poor external balances, and – most recently – falling long term yields. Market participants in the developed markets tend to lose from sight that quite a few of the key gold consumer nations are now facing inflation pressures on a scale unprecedented in the last 24 months. This does not necessarily tell us where gold prices may be going in the near term. But stronger demand on the Subcontinent will contribute to a more robust floor under the price, potentially helping to support the gold market during the traditionally weaker summer months.

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Tags: Akshaya Tritya and gold demand, gold prices in Rupee, India inflation, India interest rates