The RBI cut its policy rate by a quarter of a percentage point to 7.75%, the reverse repo rate to 6.75% and it reduced the cash reserve ratio – the percentage of the value of deposits that banks must keep with the RBI – to 4% from 4.25%.
The central bank adjusted downwards its forecasts for growth and inflation for the fiscal year ending in March 2013.
It now expects GDP to advance by 5.5% over the period, compared with an expectation of 5.8% in October, and it sees wholesale price inflation (WPI) at 6.8% in March, compared with a previous forecast of 7.5%.
The bank said there was an “increasing likelihood” that inflation would remain range-bound for the year 2013-2014.
“This provides space, albeit limited, for monetary policy to give greater emphasis to growth risks. This policy guidance will, however, be conditioned by the evolving growth-inflation dynamic and the management of risks from the twin deficits,” the bank said.
The Sensex initially rose on the news of the rate cut but ended the day 0.56% lower as investors believe the central bank is still too hawkish.
“What the economy needs most of all and most urgently is new investment,” the Indian central bank said in a statement. “This will step up currently flagging aggregate demand and also ease the supply constraints so that existing capacity is fully utilized and new capacity is built up.”
The central bank said a credible fiscal adjustment by the government, implementation of structural reforms and improving governance “to inspire the trust and confidence of potential investors” were “crucial to this effort.”
TWIN DEFICITS
The RBI’s decision to cut was “a nod to the structural policy progress the government has delivered so far,” according to Leif Eskesen, Chief Economist for India and ASEAN at HSBC.
But the bank’s statement shows that further monetary easing is conditioned on inflationary pressures easing but also on the government continuing to deliver on other policy fronts, Eskesen added. “The case for a rate cut was not strong given the lingering inflation pressures and wide twin deficits. This is why RBI only cut by 25 basis points and essentially conditioned any further rate cuts on inflation risks further receding, fiscal policy tightening, and structural reform implementation continuing,” he said.
HSBC forecast that the RBI will only cut rates by a further quarter of a percentage point this year.
Capital Economics’ analysts also expect just a quarter of a percentage point cut in Indian interest rates by December, saying that the central bank’s analysis is “fairly hawkish and suggests markets may be disappointed by the pace and degree of policy loosening.”
“The RBI attributes the slowdown primarily to weak external demand and various bottlenecks, including power supply problems due to shortfalls in coal supply, and delays in implementing large infrastructure and industrial projects due to slow agreement of environmental approvals and land acquisition. Looser monetary policy would not solve these problems,” said Andrew Kenningham, senior global economist at Capital Economics.
Any further declines in inflation are likely to be “gradual at best,” Kenningham also noted, as the central bank highlighted its worries about the pace of wage growth in the rural and manufacturing sectors and the recent liberalization of diesel prices, as well as possible hikes in administered coal and electricity prices, could push inflation higher.
On the fiscal side, the government “is struggling to meet its revised 5.3% deficit target” as revenue growth is weak, and on the external side, the current account deficit will exceed 4% of GDP for the second year in a row, he said.