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Reserve Bank of India’s delicate balancing act

The Reserve Bank of India refrained from cutting interest rates at the start of the week, placing pressure on the government to introduce fiscal reforms. However, the key to India's economic recovery lies in boosting investment – a bleak prospect, for now

The Reserve Bank of India’s (RBI) surprise move to keep interest rates on hold – even amid mounting fears about India’s once-vaunted growth trajectory – is a shot across the bows for the government to awaken from its reformist slumber, analysts say.

Interest rates were held at 8% and the cash reserve ratio (CRR) remained unchanged at 4.75% on Monday – despite market expectations of a 25 basis point cut in the respective rates – as inflation concerns overrode growth fears.

The economy slowed to 5% in the first quarter. And with a stubbornly high inflation rate of 7.55% in May, fears are growing India is trapped in stagflation, an about-turn compared with the country’s growth narrative post-crisis.

However, hawkish analysts have defended the RBI’s decision to keep rates on hold, citing the constructive pressure on the Indian government to do the heavy lifting, and inflationary pressures.

“We are pleased to see that the RBI went against consensus expectation to leave the policy stance unchanged,” says Kaushik Das, economist at Deutsche Bank in India, citing food-price inflation, still excess-liquidity, inflationary pressures caused by rupee weakness and fiscal expansion.

Previous efforts to curb inflation through interest-rate cuts have been unsuccessful. The RBI has raised interest rates 13 times between March 2010 and October 2011.

However, in an about-turn, the RBI cut lending rates by 50bp in April to boost economic growth. Despite these measures, recent economic results show that inflation increased from 6.89% in March to 7.55% in May, while the outlook for GDP growth will remain a disappointing 6% for 2012.

As Rahul Bajoria, regional economist for Asia at Barclays Capital in Singapore, says: “India’s economic slowdown has been mainly caused through supply shocks, not demand shocks. What we really need are some structural changes to fiscal and monetary policy.”

RBI's strong message

More profoundly, RBI inaction sends a strong message to the government.

Bajoria adds: “By keeping interest rates as they are, the RBI claims to be fighting inflation and supporting the currency, which they argue is more important than supporting economic growth right now. But I don’t really buy this – the RBI is justifying its actions in this way just to maintain a level of credibility. Maybe the bank is buying time and hoping for government action to come first.”

The statement by the RBI places pressure on the government to kick-start the stalled fiscal reform agenda during the next six months to boost market confidence. A bank analyst, based in India, says: “The RBI may think about cutting rates once the government introduces changes to food and fuel subsidies, which both exacerbate inflation and affect GDP growth.”

A lack of private investment and capital inflows have slammed the brakes on expansion. Equity inflows would help the country break this cycle, believes Bajoria. “If equity markets do better ... portfolio inflows come in which will support the rupee,” he says.

A pause in the monetary tightening cycle might also give banks, which are suffering from high funding costs, some breathing room. The RBI and the Indian government have called on banks to reduce their lending rates to boost domestic credit expansion.

The State Bank of India, India’s largest bank, cut lending rates between 0.5-3.5 percentage points on Friday, mainly for small- and medium-sized enterprises, and the agriculture sector, in a move seen as signalling banks’ lending appetite in return for cheaper liquidity – though interest rates cuts failed to materialize. “Banks are lobbying for an increase in liquidity and action by the RBI,” says Bajoria.

To boost liquidity, the RBI can cut the CRR, buy bonds or ease up restrictions on foreign capital. “Cutting the CRR will help solve the liquidity situation, but not a lot more,” says Bajoria. “A better solution would be the reform of the capital markets, which would lead to capital inflows, which RBI can sterilize to infuse rupee liquidity. This can, in turn, solve the liquidity crisis in banks.”

However, such reforms are unlikely in the near-term, exacerbating the high-stakes trade-off between inflation and growth. “Unless there is dramatic deterioration in external or domestic risk factors, the central bank [RBI] would likely remain on the sideline until inflation eases appreciably,” says Deutsche''s Das.

“We don’t see an easing window until the fourth quarter of this year. In our view, the next rate cut won’t be until October or later and we see about 50-75bp in rate cuts over the next 12 months. The risk, however, is that the RBI ends up doing even less.”

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