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Another day, another interest rate increase from an emerging economy central bank.

On January 25, it was the turn of the Reserve Bank of India. The bank raised its benchmark repurchase rate to 6.5% from 6.25%. The Reserve Bank of India raised interest rates six times in 2010 and the benchmark rate is now at a two-year high.

I don’t think the Reserve Bank of India is done either. The bank’s most recent projections are pointing to inflation of 7% by the end of the country’s fiscal year on March 31. That’s a huge increase from earlier projections of 5.5% inflation. (The bank is also calling for GDP growth of 8.5% for the year that ends in March. That’s unchanged from earlier projections.)

And the Reserve Bank’s projection is very likely low. Inflation in wholesale prices, India’s preferred inflation measure, hit an annual rate of 8.4% in December.

Not surprisingly Indian stocks fell on the news of the interest rate increase with the Mumbai market’s Sensex 30 Index closing down 1%. The drop was widespread—Infosys Technologies fell 0.8%, for example–but property and bank stocks were among the shares suffering the biggest declines.

Even before the interest rate increase India’s over-heated real estate market was showing signs of slowing. Home registrations in Mumbai, the country’s most expensive real estate market, fell in November to their lowest level in 20 months. (Property prices climbed 30% to 70% across India in 2010.)

India’s banking sector is already reeling from a scandal in which officials at some of the country’s state-run banks took bribes to approve loans and it still hasn’t completely recovered from a rise in bad loans during the global financial and economic crisis.

Of India’s big private banks the one that worries me most here is ICICI Bank (IBN). The bank had just started to recover from two years of deteriorating credit quality but non-performing loans still made up 5% of the bank’s portfolio at the end of the October quarter. (Contrast that to the 2% non-performing loan ratio at competitor HDFC Bank (HDB) at the peak of its non-performing loan problem in mid-2009.) Higher inflation, much of which is a result of higher food prices, cuts deeply into the purchasing power of India consumers and then ripples out into consumer and corporate loans.

I certainly wouldn’t be adding to any bank positions in India until the Reserve Bank gets closer to the end of this interest rate cycle. And I would be actively reducing positions in ICICI Bank right now.

HDFC Bank is a member of my Jubak Picks 50 long-term portfolio

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did own shares of HDFC Bank and ICICI Bank as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at