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RBI warns of growth risk ahead of rate decision

business Updated: Oct 25, 2011 09:31 IST

The RBI said inflation remains "sticky" even though risks to growth have risen, while weakening investment imperils growth for the next fiscal year, complicating its policymaking task a day before it is expected to raise interest rates.

Tuesday's forecast rate increase by the Reserve Bank of India (RBI) would be its 13th since March 2010.

"The baseline inflation path still remains sticky and broadly unchanged from earlier projections. On the other hand, growth risks have increased on account of global headwinds and domestic factors," the central bank noted on Monday in its quarterly report on macroeconomic and monetary developments.

India's economy grew at 7.7% in the June quarter, its weakest pace in six quarters, but inflation came in at 9.7% in September despite monetary policy tightening that has made the RBI one of the most aggressive central banks anywhere over the last year-and-a-half.

It said it was "inevitable" that some growth would be sacrificed in a high inflation environment.

Of 30 analysts polled last week by Reuters, 17 expect the Reserve Bank of India to increase the key lending rate by 25 basis points on Tuesday, while 13 expect it to hold the rate steady. The forecasts were among the most balanced in recent quarters.

"The language has definitely softened," said Rupa Rege Nitsure, chief economist at Bank of Baroda in Mumbai.

"Earlier, language used to stress more on management of inflation alone," she said, adding that Monday's report reinforces her expectation that the central bank will leave rates on hold on Tuesday.

The central bank said investment demand is softening due to tighter monetary policy, impediments to completing big projects, weakening business confidence and a slowing global economy.

It said planned investment in new projects has fallen "significantly" since the second half of the fiscal year that ended in March, and remained low in the April-June quarter, when project finance data from 33 banks showed a 44% drop-off in loan approvals from a year earlier.

"Consequently, the pipeline of investment is likely to shrink, putting growth in 2012-13 at risk," the RBI's report said. The 2012-13 fiscal year starts in April 2012.

Since March 2010, the RBI has raised the repo rate, its policy interest rate, by a total of 350 basis points to 8.25%, and its recent hawkishness has made it an outlier at a time when central banks elsewhere are focused on boosting growth.

Whatever the RBI does on Tuesday, it is then widely expected to leave rates on hold for the remainder of the fiscal year.
However, inflation remains well above the RBI's March 2012 projection of 7%, and the central bank noted that the recent decline in the rupee, which is down more than 13% against the dollar since its 2011 peak in late July, adds a new source of inflationary pressure.

The central bank said India was unlikely to benefit significantly from a decline in global commodity prices, given domestic subsidies that partly insulated it from earlier high prices.

It said domestic food inflation remains high due to demand-supply mismatches in non-cereal crops and upward revisions in government price minimums.

The RBI's perceived comfort zone for inflation is 4-4.5%.

"Domestic price pressures still remain significant and broad-based," the RBI noted.