Bloomberg News

India Deficit Above 5% for Second Year Limits Rate-Cut Room

March 17, 2012

The Reserve Bank of India’s scope for a series of interest-rate cuts to bolster a slowing economy may be hampered by inflation risks from a budget deficit projected to exceed 5 percent for a second year.

Benchmark bonds capped their biggest weekly decline in seven as Finance Minister Pranab Mukherjee unveiled an annual budget yesterday that will require record borrowings of 5.69 trillion rupees ($113 billion) to finance a gap estimated at 5.1 percent of gross domestic product. The deficit for the year through March 31 is projected at 5.9 percent, wider than the 4.6 percent target set in 2011.

Mukherjee, who proposed a cap on subsidies and raised service and excise taxes, said today the higher levies could spur price gains. Borrowing costs at the highest level since 2008 to fight inflation, policy gridlock and slumping investment contributed to a slowdown in growth to 6.1 percent last quarter, the weakest pace since 2009.

“The RBI said that it was waiting for the budget to crystallize on the timing and magnitude of rate cuts,” said Killol Pandya, the Mumbai-based head of fixed-income investment at the local unit of Daiwa Asset Management Co. “This budget does not give any comfort. It raises concern of the RBI pushing back its timelines regarding rate cuts.”

Interest-Rate Decision

The increase in both service and excise taxes to 12 percent from 10 percent may lead to “some inflationary pressures and I do not rule out that possibility,” Mukherjee said in an interview with Bloomberg UTV in New Delhi today.

At the same time, the minister said he doesn’t expect central bank policy to be influenced by the budget. Investment is set to recover, he also said.

The Reserve Bank of India left interest rates unchanged at 8.5 percent for a third meeting on March 15, joining Asian nations from Indonesia to South Korea in holding borrowing costs. While it reiterated that future actions will be toward lowering rates, the central bank said lingering inflation risks will influence the timing and magnitude of such moves.

The monetary authority also said “credible fiscal consolidation” will be an “important factor” in shaping the inflation outlook. After the budget, Deputy Governor Subir Gokarn said the estimated reduction in the fiscal deficit is a “significant correction” and that the commitment to cap subsidies is important.

Widest BRIC Deficit

One-year interest-rate swaps, or derivative contracts used to guard against fluctuations in funding costs, rose by 17 basis points since March 14 to a more than four-month high of 8.22 percent, reflecting investors’ concern the central bank may delay reduction in interest rates. The rate rose five basis points yesterday. The yield on the 8.79 percent bonds due November 2021 jumped 14 basis points this week to 8.43 percent, the most since the period ended Jan. 27.

Asia’s third-largest economy has the widest fiscal deficit among the so-called BRIC nations that also include Brazil, Russia and China. It has the group’s fastest inflation, with India’s benchmark wholesale-price index climbing 6.95 percent in February from a year earlier.

“It doesn’t appear that the RBI is in a hurry to immediately start cutting rates,” said Shubhada Rao, chief economist at Yes Bank Ltd. (YES) in Mumbai. “They will digest the budget arithmetic more closely and they would simultaneously view the cues for global crude prices.”

Crude-Oil Surge

Brent crude, the benchmark for almost all of India’s imports, has jumped about 15 percent so far this year. India imports three-quarters of its oil.

Mukherjee proposed yesterday a cap of less than 2 percent of GDP in the next fiscal year on a subsidy program that spans diesel to fertilizers.

While the subsidy cap would be positive for India, implementation risk is “high” ahead of the 2014 general election, Fitch Ratings said. Public finances have been “deteriorating and remain a key weakness” in India’s credit rating, it said.

“The government might pass through significant amounts of the tightness in crude prices and if that happens then it will have an impact on inflation,” Daiwa’s Pandya said. “That puts a question mark on the RBI’s stance on interest rates.”

The Reserve Bank raised borrowing costs by a record 3.75 percentage points from 2010 to October last year to fight price rises. It unexpectedly cut the amount of deposits lenders need to set aside as reserves on Jan. 24 and March 9 to ease a cash squeeze, lowering the cash reserve ratio to 4.75 percent.

Coalition Under Pressure

Prime Minister Manmohan Singh’s Congress party-led government faces pressure to support the 69 percent of India’s 1.2 billion population living on less than $2 per day. State-run Indian Railways’ plan to raise passenger fares, announced this week, drew criticism from within the ruling coalition, highlighting its frailty.

Moody’s Investors Service said March 8 that India needs “persistent” policy efforts over several years to narrow a deficit that if left unchecked will hurt the economy. Slowing growth has hampered tax revenues even as subsidies and a job guarantee program for rural workers spur spending.

The government predicts GDP may rise 6.9 percent this fiscal year, compared with 8.4 percent in the previous one. Mukherjee estimated GDP may rise as much as 7.85 percent in the year through March 2013 and that inflation will ease in coming months.

The budget “can probably be best described as a good old- fashioned tax and spending plan,” said Robert Prior- Wandesforde, Singapore-based director of Asian economics at Credit Suisse Group AG. “Sadly, but not unexpectedly, proposals for radical economic reform were largely notable by their absence.”

To contact the reporter on this story: Unni Krishnan in New Delhi at

To contact the editor responsible for this story: Shamim Adam in Singapore at

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