MUMBAI: Indian stocks, the most expensive in the largest emerging markets, may fall as a surprise interest rate increase hurts financial and consumer shares, while the rupee is poised to extend gains, EM Capital Management LLC and Prudential Financial Inc. said.

The Bank of New York Mellon India ADR Index, which tracks U.S.-traded shares, fell the most in six weeks on March 19 after the central bank raised the reverse repurchase rate to curb inflation. The rupee fell 0.09% to 45.4966 and is up 11.3% the past year.

The benchmark Sensex stock index may drop 200 points in a "knee-jerk reaction" today, according to CNI Research (India) Ltd. Speculation that countries from China to Brazil will raise borrowing costs next may hurt demand for shares in other developing nations as well, according to Prudential. The MSCI Emerging Markets Index climbed 0.9% this year, half the gain of the MSCI World Index.

"We expect the impact of this rate hike to be relatively bigger on emerging-market stocks," said John Praveen, the Newark, New Jersey-based chief investment strategist at Prudential International Investments Advisers LLC, a unit of Prudential Financial Inc., which oversees $667 billion. "The start of the interest-rate normalization in India is likely to fuel fears of early rate hikes in China, Brazil and other emerging markets."

Bond Gains

The Sensex has advanced 96% in the past year to 17,578.23. Benchmark Indian bonds climbed 16% over the same period, according to JPMorgan Chase & Co. data. The gains made India the third-best performing stock, bond and currency market in Asia.

The advance in shares drove Sensex's valuations to 21.4 times estimated earnings, almost three times the 7.9 multiple in November 2008. That's the most expensive among the BRICs and also in Asia excluding Japan, data compiled by Bloomberg show.

"Predictions are that Indian stocks will slide when the market opens," said Seth Freeman, chief executive officer of San Francisco-based EM Capital.

Banks, Developers

Freeman, whose 159% return in stocks over the past year beat 96% of 420 funds investing in the nation's equities, said banks, developers and some consumer stocks such as automakers may be affected by the rate increase. "Better buys" in the market include Financial Technologies (India) Ltd., operator of a commodities exchange, and Fortis Healthcare Ltd., which runs a chain of hospitals, he said.

The Reserve Bank of India's decision to raise the benchmark reverse repurchase rate to 3.5% from a record-low 3.25% and the repurchase rate to 5% from 4.75% came a month before its scheduled monetary policy meeting. Policy makers said containing inflation has become "imperative" after the wholesale- price inflation rate reached a 16-month high of 9.89% last month.

The central bank will probably raise interest rates again next month as the first increase in two years is only the initial step in the battle against inflation, BNP Paribas SA and Standard Chartered Plc said.

China Reserves

China raised the amount banks need to set aside as reserves two times this year, while Malaysia and Vietnam increased lending rates as inflation accelerates. Brazil's central bank kept its benchmark interest rate at a record low this month in a less-than-unanimous decision, signaling that borrowing costs may rise as soon as April.

The stock market is "fully valued," said Sanjeev Prasad, an executive director at Kotak Securities Ltd. who is a top-ranked analyst in the past four years in Asiamoney polls. He said automakers and developers will be hurt most by an expected 2%age point rate increase in the fiscal year starting April 1. State-run banks may also have to write down the value of investments, he said.

SBI Funds Management Ltd., a unit of the nation's biggest bank, predicts the yield on benchmark 10- year bonds will peak at between 8.25% and 8.50% from 7.83%, providing an opportunity to lock in relatively high yields.

'Long-Term Call'

"If one takes a long-term call, these levels should be good to accumulate as it would provide an adequate cushion against inflation," SBI Funds Chief Investment Officer Navneet Munot said in an interview. "The long-term inflationary expectations are getting anchored around 5%."

Foreigners more than doubled holdings of debt this fiscal year, raising total ownership to an all-time high of $11.2 billion on March 18, to benefit from the rising yields on the nation's assets. Outstanding overseas investment in stocks also climbed to a record $76 billion on the same day.

"The rate hike is proof that the economy is doing very well and I would draw some comfort from that," said Krishnamurthy Harihar, treasurer at the Indian unit of FirstRand Ltd., South Africa's second-largest financial services company. He predicts the rupee may rise as much as 2.2% to 44.50 by June on increased foreign inflows and a cooling in food-price inflation.

Prudential's Praveen, who said the higher borrowing costs won't "choke" the economic recovery, expects the rupee to rise as the U.S. Federal Reserve keeps lending rates low. India's $1.2 trillion economy, Asia's biggest after Japan and China, is expected to expand 8.2% in the next fiscal year, compared with 7.2% in the year to March 31, the Finance Ministry said in February.

Opposition parties repeatedly stalled proceedings in parliament this month and accused Prime Minister Manmohan Singh's government of being anti-poor and failing to curb prices. The World Bank estimates three-quarters of the nation's 1.2 billion people live on less than $2 a day.

The rate increase underscores the "seriousness of the inflation problem," said Jagannadham Thunuguntla, chief strategist at SMC Capitals Ltd., the investment banking arm of SMC Group in New Delhi. "Investors can surely liquidate half of their portfolios."