Bloomberg News

India Goal to End Rate Increases May Hinge on Fiscal Policy

October 26, 2011

(Updates with comment from governor in 11th paragraph.)

Oct. 26 (Bloomberg) -- Indian central bank Governor Duvvuri Subbarao’s plan to end a record cycle of interest-rate increases may hinge on the government’s ability to rein in its “expansionary” budget.

“In the absence of fiscal measures to address inflation, we are going to see elevated levels of inflation for an extended period of time,” said Leif Eskesen, a Singapore-based economist at HSBC Holdings Plc. “If the fiscal policy is not adjusted, they are putting more burden on other policy makers.”

Subbarao is under pressure to shield India’s economy from Europe’s debt crisis and a faltering U.S. recovery, after counterparts in Brazil and Russia lowered borrowing costs in recent weeks. The Reserve Bank of India yesterday raised interest rates for a 13th time since the start of 2010 and signaled it’s nearing the end of its tightening.

“Should the fiscal deficit level slip from the budgeted level, it will have implications for domestic inflation,” the Reserve Bank said in a statement in Mumbai yesterday after it raised the repurchase rate to 8.5 percent from 8.25 percent. The central bank said the likelihood of a rate action in December is “relatively low” as it expects inflation to slow by the end of the year.

The yield on the 7.80 percent government note due 2021 dropped six basis points, or 0.06 percentage point, to 8.76 percent at the close of trading in Mumbai yesterday, paring declines of as much as 14 basis points immediately after the central bank policy statement.

Stocks Climb

The BSE India Sensitive Index climbed 1.9 percent, and the rupee strengthened 0.7 percent to 49.51 per dollar yesterday. India’s financial markets are closed for holidays today and tomorrow.

The rupee has weakened about 10 percent against the dollar this year as investors sold stocks in emerging markets because of risks to global growth, making the currency the worst performer in Asia and threatening to boost import costs.

“Two factors have made RBI’s inflation fight a lot harder -- accommodative fiscal leaning and weak rupee,” Radhika Rao, an economist at Forecast Pte in Singapore, said in a note after the rate decision. While the central bank may hold rates in the coming months, “signs of stickiness in prices into late year or early next could see the RBI keep the door open for another rate tweak,” she said.

India’s benchmark wholesale-price inflation was 9.72 percent in September, staying above 9 percent since the start of December. By comparison, consumer prices rose 7.3 percent in Brazil, 6.1 percent in China and 7.2 percent in Russia.

Inflation Forecast

Inflation will start to cool from December and ease to 7 percent by the end of March before moderating further in the first half of the new fiscal year starting April 1, the central bank said. Beyond December, “if the inflation trajectory conforms to projections, further rate hikes may not be warranted,” it said.

“Seven percent inflation is above the comfort zone of the Reserve Bank and above the vast majority of people in India, if not the entire population of India,” Subbarao told analysts on a conference call today. “So, inflation has to come down below 7 percent before we contemplate reversing our policy stance.”

Even so, the central bank said the government’s “large” budget deficit has been an “important source” of demand pressure. “Clearly, the impact of tightening monetary policy has been diluted by the expansionary fiscal position, which is a sub-optimal outcome,” it said.

“Rate increases have not had the desired impact on inflation as fiscal policy stays loose,” said Amol Agrawal, a Mumbai-based economist at STCI Primary Dealer Ltd. “Monetary policy alone can’t curb price gains. The government needs to cut its budget deficit too.”

Budget Deficit

India’s budget shortfall may widen to as much as 5.5 percent of gross domestic product in the year ending March 31, more than the government’s 4.6 percent target, because of higher spending on fuel and food subsidies, Agrawal said.

“Obviously, meeting the deficit target remains a challenge,” Finance Secretary R.S. Gujral said in an interview yesterday. “Let us see what we can do.”

The monetary policy unveiled “would help in getting us back to a more comfortable inflation situation soon while leaving scope for growth to pick up in the second half of the current fiscal year,” India’s Finance Minister Pranab Mukherjee said in a statement in New Delhi yesterday.

Subbarao has increased the central bank’s benchmark rate by 375 basis points since mid-March 2010, the fastest round of increases since the central bank was established in 1935, Bloomberg data show.

Manufacturing Eases

That’s curbing consumer demand. Manufacturing in India grew in September at the slowest pace in 2 1/2 years, according to the Purchasing Managers’ Index released by HSBC Holdings Plc and Markit Economics.

The central bank yesterday cut India’s growth forecast for the current fiscal year to 7.6 percent from 8 percent. That would be the second slowest expansion in nine years.

India’s automakers on Oct. 10 cut their car sales growth forecast for a second time this year as companies including Honda Motor Co. and Ford Motor Co. faced lower demand.

“It’s now time to assess the impact of the previous rate hikes on the economy and that’s a very appropriate stance,” said Sanjay Mathur, Singapore-based head of research and strategy for non-Japan Asia at Royal Bank of Scotland Group Plc. “The damage that rate increases are starting to inflict on the economy is getting larger.”

--With assistance from Unni Krishnan and Anto Antony in New Delhi. Editors: Cherian Thomas, Stephanie Phang

To contact the reporter on this story: Kartik Goyal in New Delhi at

To contact the editor responsible for this story: Stephanie Phang at

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