Reserve Bank of India Governor Duvvuri Subbarao fired the bazooka from his arsenal to revive flagging economic growth with a 50-basis-point cut in interest rates, but said he will not hesitate to raise rates again if price pressures revive.
The unexpectedly steep reduction - the markets had expected a 25-basis-point cut - coming in the wake of a growing clamour from government officials and businessmen to cut rates, even though demand pressures persist, raised questions whether the governor is risking his credibility.
Subbarao, a former finance secretary, had for much of the past year ignored markets and advice from an internal panel to reduce rates, resulting in howls of pain from business but burnishing the central bank's inflation-fighting credentials.
The governor, in an interview to ET, described the decision as a "professional judgement" guided entirely by the numbers on growth and inflation. "I don't think you should read us by what people are expecting us to do, or should read us by whether we deliberately want to surprise the market. That's a professional judgement. We have taken into account both growth and inflation dynamics."
Tuesday's reduction in lending rates, the first in three years, was widely welcomed by businessmen and hailed by the finance minister.
"The growth which has weakened in past months should now improve. The monetary policy announcement should help in investment revival and contribute to strengthening of business sentiments," Finance Minister Pranab Mukherjee said in Delhi.
In interviews after the presentation of the Union Budget, finance ministry officials had been increasingly strident in their calls for a change in monetary policy.
Earlier Tuesday morning, addressing a meeting of the Confederation of Indian Industry, Mukherjee said they could expect some "good news" as the RBI was likely to soften its monetary policy in about "half an hour", though he did not disclose details. This was around 10:38 am. The minister's words were somewhat unusual as news of the rate cut was embargoed till the official announcement at 11 am.
The RBI also boosted liquidity measures by doubling banks' borrowing limit under the so-called Marginal Standing Facility to 2% of their demand and time deposits.
This could smoothen money market movements and help the government's borrowing programme.
The rate cut is aimed at boosting investments, but many expressed doubts on whether corporates and individuals will benefit immediately as banks are reluctant to commit to lower borrowing costs immediately.
"Both deposit and lending rates will come down, though it may take a while," said Aditya Puri, CEO at HDFC Bank.
"If government spending comes in, leading to an increased money supply and consequent velocity into the banking system, we do expect that deposits will grow."
When that happens, yes, there will be enough money. Bankers will be brave. In the interim, it may lead to blood pressure rather than bravery," Puri added.
The central bank also sought to help the consumer by abolishing prepayment charges on home loans after banks failed to do so despite persuasion, and bringing in more transparency in interest rates on deposits.
Subbarao cut repo rate - the rate at which it lends to banks - by 50 basis points, double of what the market expected, to 8%.
Reverse repo - the rate it pays banks when they deposit surplus funds - fell to 7% and the penal rate of interest on borrowings by banks under MSF dropped by the same amount to 9%. The RBI kept some power dry by leaving the cash reserve ratio untouched at 4.75%.
"Expectations are that pricing power of corporates is quite limited so they may not be able to pass on the increase in input prices as they were able to do for much of the past oneand-a half years," Subbarao said.
"Therefore, supply shocks or adjustment in administered prices may not transmit to generalised inflation. But if our calculations go wrong, our policy prescriptions will have to be different.'' The finance minister vowed to step up the fight against inflation. "Food and primary inflation have shown signs of hardening.
This is a cause for some concern. We intent to continuously monitor the situation and take the required steps to manage short-term supply constraint for those food items that contribute to inflation. We will do everything possible to maintain price stability." The benchmark Sensex rose 1.2% to 17,358.
The yield on the 8.79% bonds due November 2021 fell 12 basis points to 8.34%, the lowest since March 14. The rupee climbed 0.4% to 51.48 to the US dollar. "It has merged a couple of 'baby steps' into today's move and will possibly stay on hold for a while," said Siddhartha Sanyal, economist at Barclays.
"We believe the central bank will examine the scope for further monetary easing on a case-by-case basis in the coming months, with a bias towards not cutting repo rate further in the next one to two policy meetings."
Gross domestic product may expand 7.3% this fiscal compared with the baseline projection of 7% last year, Subbarao said. Inflation will probably be at 6.5% by March 2013. He forecast bank deposits to grow 16% and commercial credit 17%.
But the government's fiscal position, borrowings of a record Rs 4.8 lakh crore, and suppressed inflation in the form of lower petroleum product and coal prices could throw a wrench in the works. "Large borrowings have the potential to crowd out credit to the private sector," said Subbarao.
"Crowding out of the more productive private credit demand will become more critical if there is fiscal slippage." But the liquidity-boosting measures may possibly take care of the market conditions despite huge borrowings by the government.
"The surprise was the increase in MSF to 2%, which clearly is an effort to cap borrowing costs within the corridor of 8-9% and not let temporary factors due to frictional liquidity lead to unintended tightness in inter-bank markets," said B Prasanna, managing director and CEO at ICICI Securities Primary Dealership Ltd. The generous rate cut and liquidity-boosting measures may push up prices again, even as high interest rates have failed to completely tame prices so far.
The central bank has been missing the inflationary forecast for many years. Its desired level of 4-4.5% and long-term target of 3% in line with international standards may remain a dream. "The RBI was clearly itchier to cut policy rates more than expected, but the 50-basis-point cut may have been a bit too premature and aggressive," said Leif Eskesen, regional economist at HSBC.
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