Global investment banking giant Goldman Sachs has slashed India's growth forecast for this fiscal to 7.8% on account of rise in interest rates and an uprising inflation, forecast at 7.5% during the period.
The estimate is way below the government's forecast of 9% growth in 2011-12.
"We reduce our GDP growth forecasts for FY12 to 7.8% from 8.7% due to the impact of higher rates...," Goldman Sachs said in its latest issue of 'Asia Economics Analysts'.
The bank had earlier forecast that the Indian economy would expand by 8.7%, while the inflation would hover around 6.7% in 2011-12.
Goldman Sachs says the environment remains challenging, with inflationary pressures persisting into the economy. According to its latest report, recent spike in core prices suggest that the food and fuel shocks have been passed through and inflation may remain elevated in 2011.
"We are raising our inflation forecast for FY12 to 7.5% from 6.7% due to the recent large upside surprise in core prices," Goldman Sachs said.
Headline inflation has remained above 8% since February 2010. Overall inflation in March stood at 8.98%, much above the government's projection of 8%.
Food inflation remained in double digits for greater part of last fiscal, though it has shown signs of moderation since March.
Prime Minister Manmohan Singh had yesterday admitted that inflation, specially of food items, is a matter of concern for the government.
Goldman Sachs expects RBI would continue with it tight monetary policy this year to staunch the inflationary pressures.
"With inflation remaining the dominant macro concern, we think that the RBI will keep liquidity tight in order to pass through the policy rate hikes to bank deposit and lending rates.
We now expect RBI to hike policy rates by another 125 bp in 2011, significantly higher than the market expectations," Goldman Sachs said.
RBI has already hiked key policy rates eight times since March 2010, totalling to around 200 basis points, to drain out liquidity from the system.
Goldman Sachs, however, said that real interest rates have actually fallen by about 100 basis points since November 2010 on account of higher inflation expectations.
"We think system liquidity may remain tight due to government borrowing, a high credit-deposit ratio, and a weaker balance of payments... Recently recommended changes to the central bank’s operating procedures also state the intention of keeping system liquidity tight, and banks in borrowing mode," it said.
Goldman noted that from the production side, the main slowdown in growth momentum comes from the industry due to the rate increases.
"Agriculture should suffer from a high base from FY11," it added.
According to the report, the country's fiscal deficit is likely to be 5.2% of GDP in 2011-12, higher than the budget estimate 4.6%.
"Fiscal policy may be unable to contract sufficiently due to the subsidy burden of higher oil and fertilizer prices. If higher oil prices are not passed through, the fiscal deficit will likely be higher than the budget estimates...the RBI would need to contain second-round effects of food and energy shocks," it said.
Global crude prices have soared above $120 per barrel as supplies from Libya, an OPEC member and key exporter, have dried up on account of fighting between government and rebel forces.
India imports three-quarters of its oil and gas, and price of diesel continue to remain regulated.