The Reserve Bank of India (RBI) unexpectedly slashed its key lending rate for the first time in more than four years on Monday in a fresh attempt to shield the economy from the global financial crisis.
Shares and the rupee initially jumped and bond yields fell after the RBI cut its repo rate by 100 basis points to 8.0 percent with immediate effect, just four days ahead of a scheduled policy review.
The move comes about two weeks after major central banks, including in the United States, Europe and China, cut interest rates in unison to try to restore confidence in markets.
Other Asian economies, including Taiwan and South Korea, have taken similar action following the financial storm unleashed by the collapse of Lehman Brothers.
India's policy makers have taken a slew of measures in recent weeks as foreign capital was pulled out of the stock market and as credit markets seized up as onshore liquidity evaporated in part because banks were wary of lending.
"Funding constraints, capital outflow and recessionary global conditions are likely to put pressure on the growth momentum and the central bank thus is looking to counter that drag," said Gaurav Kapur, senior economist at ABN AMRO Bank.
Prime Minister Manmohan Singh said growth could slow to 7.5 percent in 2008/09 from 9 percent last fiscal year as the turmoil took its toll on Asia's third-largest economy.
"The precise impact is difficult to estimate at this point since the depth and duration of the global slowdown remains uncertain," Singh told parliament after the rate cut.
The government also asked parliament to approve an extra $21.7 billion in spending in the fiscal year to March as its subsidy bill has gone up due to high fuel and food prices, and analysts said this would put pressure on public finances.
RIPPLE EFFECT
The 13-year federal bond yield fell 37 basis points on the day to 7.70 percent after the rate cut. The benchmark 10-year bond was not traded due to interest payments.
The stock market, which on Friday closed at its lowest since June 2006, jumped as much as 5.6 percent but then pared gains to close up 2.5 percent.
Separately, the capital market regulator said it had told foreign investors it disapproved of lending and borrowing local stocks abroad as this caused selling pressure in the cash market.
The partially convertible rupee rose before edging down to 49.20 per dollar on defence-related dollar buying, nearing a recent record low before state-run banks sold dollars to prop it up to 49.00, probably on behalf of the RBI.
The Reserve Bank said calm had yet to be fully restored to financial markets despite aggressive action by countries directly affected by the crisis.
"Due to financial integration, this uncertainty is transmitting also to countries outside the epicentre of the crisis," it said in a statement.
India has been particularly vulnerable to rising risk aversion among foreign investors. They have pulled $12 billion this year from the stock market, which has fallen by half after rising by 47 percent in 2007.
That in turn has hit the rupee. A loss of capital inflows from foreign portfolio investment could add to pressure on the balance of payments because the current account deficit is already running at nearly 2 percent of gross domestic product.
The credit strains have started making an impact on the broader economy, with airlines cutting costs and some struggling to get funding from banks, and real estate developers offering big discounts on residential property.
And with industrial output growing just 1.3 percent annually in August, its slowest pace in a decade, and inflation still in double digits, economic worries are growing for the government ahead of five state elections towards the end of the year and national polls next year.
Markets had speculated the RBI might ease policy at a review scheduled for Friday, and economists said the timing of the cut showed rising concern over the growth outlook and the flow of bank credit. For a rates chronology, see
The RBI, which faces an employee strike over pensions on Tuesday, also cancelled a 100 billion rupee ($2 billion) bond auction on Monday for the second time, saying market participants could re-bid at a later date.
Overnight lending rates, which soared to 23 percent earlier in the month, have subsided to around 6 percent after 1 trillion rupees was released via big cuts in cash reserve requirements.
"The repo rate cut is a signalling device for banks to kickstart lending to companies," said Han-Sia Yeo, a strategist at Bank of America in Singapore.
"But it is still too early too say whether it would lead to aggressive lending rate cuts as market conditions are too volatile."
