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Mumbai: The Reserve Bank of India (RBI) on Tuesday kept its key policy rates unchanged and indicated that it was not ready to relax monetary policy yet, despite an easing of consumer price inflation in recent months.

RBI kept the repo rate, at which it infuses liquidity in the system, at 8%, and the reverse repo rate, at which it drains liquidity from the system, at 7%.

It also held the cash reserve ratio (CRR), or the portion of deposits that banks must keep with the central bank, at 4% while lowering the statutory liquidity ratio (SLR), or the portion of deposits that banks must invest in government bonds, by half-a-percentage point to 22% to free up funds for lending when credit growth picks up.

The reduction in SLR will free up about 40,000 crore in the banking system, given its total deposit base of about 80 trillion.

The decision to hold rates steady had been expected. With the goal of lowering consumer price inflation to 8% by January within sight, RBI signalled that its focus has now shifted to its target of bringing it down further to 6% by January 2016, which may require interest rates to stay at or near current levels.

“I want to emphasise that the RBI in no way will hold rates high any longer than necessary. There is a path we are trying to achieve. We are not against growth but we do think that the growth will be most benefited if we disinflate the economy and we don’t have to fight this fight again. Let’s fight the anti-inflation fight once and let’s win," RBI governor Raghuram Rajan said.

The finance ministry, which has been striving to stimulate economic growth that slumped to sub-5% levels for two consecutive years, backed the central bank’s moves.

“The Finance Ministry states that on its part, the Government remains committed to the path of fiscal consolidation and reviving the investment cycle that will help bring down inflation and pick-up growth further," the ministry said in a statement.

“The Governor, RBI has already stated that RBI will not hold interest rates high any longer than is necessary and if disinflation proceeds as warranted, there will eventually be room to cut rates. The Ministry further states that going forward, the RBI should examine the liquidity situation, inflation and growth in setting policy rates."

Explaining its stance in the policy statement, RBI said upside risks to the target of bringing inflation down to below 8% by January 2015 remain, although the risks are less pronounced now than in June. Inflation, as measured by the consumer price index (CPI), fell to 7.31% in June, from 8.28% in May.

“It is, therefore, appropriate to continue maintaining a vigilant monetary policy stance as in June, while leaving the policy rate unchanged," said the statement.

A reference in RBI’s June policy statement about the possibility of a rate cut, if inflation eases faster than expected, was conspicuously absent from the policy statement on Tuesday although Rajan said the room for rate cuts will be created if inflation eases on anticipated lines.

“If disinflation proceeds as warranted, we will eventually have room to cut rates," Rajan said.

Economists noted the absence of any hints in the policy or the governor’s statements of an impending rate cut.

“The communication in this policy is decidedly more hawkish than what the market would have liked," said Indranil Pan, chief economist at Kotak Mahindra Bank Ltd. Rating company Crisil Ltd ruled out any change in policy rate this fiscal, as inflation may rise in the months ahead “once the base effect vanishes".

Sonal Varma, economist at Nomura Securities Co. Ltd, also said a prolonged pause on interest rates is likely.

“ ...inclusion of new language acknowledging upside risks to its 6% target by early 2016 and removal of mention of scope for policy easing shifted the policy statement in a slightly more hawkish direction as RBI was probably underwhelmed by the budget, where tough decisions on subsidy control were once again skirted," said Mole Hau, economist at BNP Paribas.

In its budget in July, the National Democratic Alliance (NDA) kept the fiscal deficit target at 4.1%, unchanged from the target set by the previous government. However, in the absence of any significant moves to lower spending on subsidies, that target has been termed ambitious by analysts and rating agencies.

Still, Rajan said there was no reason to doubt the government’s resolve to move towards fiscal consolidation.

Rajan explained that the cut in SLR would help ensure that financing is available for productive sectors once demand for credit picks up, adding that cutting SLR at a time when credit demand is low will help prevent a flight of money from government bonds.

The cut is also partially because of the requirements of the Basel III international regime, which would require banks to maintain higher capital and more liquidity, said Rajan.

Bond markets reacted negatively. The 10-year bond yield ended at 8.61%, up from its previous close of 8.5%. Bond yields and bond prices move inversely.

“The tone was definitely not dovish and expectations are that banks may offload some holdings of government securities, though it remains to be seen as to how much of an impact it will have on yields because banks are currently holding SLR way above the mandatory level," said S.P. Prabhu, vice-president, fixed income, IDBI Federal Life Insurance Co Ltd.

Along with the SLR cut, to further enhance liquidity in the money and debt markets, RBI also lowered banks’ investment limit in the held-to-maturity (HTM) category of bonds to 24% from 24.5% earlier. HTM is a category in which the banks don’t have to price their bond holding at current market price, which forces them to incur nominal losses.

“...there exists a significant pressure given the already excess supply along with a lot of uncertainty on monsoon and meeting of 4.1% fiscal deficit target. The reduction in the HTM category further reduces the risk appetite of the banks, adding to the pressure," said Upasna Bhardwaj, economist at ING Vysya Bank Ltd. ING Vysya Bank expects the 10-year bond yield to trade in the range of 8.40-8.70%.

While banks did not commit on a lending rate cut based on the excess liquidity they got, Oriental Bank of Commerce cut its deposit rates in baskets maturing between six months to three years by 25 basis points. One basis point is one-hundredth of a percentage point.

State Bank of India chief Arundhati Bhattacharya said the SLR cut move “is not intended to trigger an interest rate cut", and that RBI will hold rates for a long period. “Banks will thus need to factor possibly a prolonged policy pause in their decision making," she said.

Industry, however, took comfort from RBI’s assessment of the economy.

The central bank said “prospects for reinvigoration of growth have improved modestly", while firming up of export growth should support manufacturing and service sector activity.

It added that its estimates of real gross domestic product (GDP) growth of 5.5%, within a range of 5-6%, can be sustained, if the recent pickup in industrial activity is sustained in an environment conducive to the revival of investment and unlocking of stalled projects, “with ongoing fiscal consolidation releasing resources for private enterprise, external demand picking up and international crude prices stabilizing".

Economic growth slumped to sub-5% levels for two consecutive years as high borrowing costs, stalled projects and subdued consumer sentiment took their toll.

“The statement from RBI today re-affirms that the economy is on the mend. The emerging green shoots need to be nurtured and we are confident that both the government and the central bank will continue to move in that direction", said Sidharth Birla, president of the Federation of Indian Chambers of Commerce and Industry.

Recent data suggested that manufacturing and services activity are picking up pace. However, economic growth is still weak, with the March quarter GDP growing at only 4.6% against its March 2011 quarter growth rate of 9.6%.

The Index of Industrial Production (IIP) rose to 4.7% in May from 3.4% in April. In March, IIP had a reading of negative 0.5%.

The HSBC Purchasing Manager’s Index for services fell to 52.2 in July, data released half an hour before the policy showed, from 54.4 in June. The index was at 50.2 in May. The index for manufacturing came in at 53 in July compared with 51.5 in June and 51.4 in May. A reading above 50 indicates expansion.

RBI’s monetary policy announcement had limited effect on the equity and currency markets. The BSE’s benchmark equity index Sensex rose 0.72% to close at 25,908.01 points on Tuesday, while the broader Nifty index of the National Stock Exchange gained 0.82% to 7,746.55 points. The rupee ended at 60.85 per dollar, up 0.15% from previous close of 60.94, tracking the gains of the stock market.

Joel Rebello contributed to this story.

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