India's central bank cut its policy rate by 25 basis points to 7.50 percent, as expected, but said it had limited to room to cut rates further given the inflationary pressures and the risks from the current account deficit.
The Reserve Bank of India (RBI), which cut its rate by 25 basis points in January following cuts of 50 points in 2012, said headline inflation is expected to be range-bound around current levels in the coming 2013/14 fiscal year but there are "adverse implications for inflation expectations" from elevated food prices and increases in minimum support prices (MSP) that is driving a wedge between wholesale and retail price inflation.
While exports the trade deficit narrowed in February due to higher exports and lower non-oil imports, the RBI said the current account deficit in the first 11 months of the current fiscal year widened from last year.
"Although capital inflows, mainly in the form of portfolio investment and debt flows, provided adequate financing, the growing vulnerability of the external sector to abrupt shifts in sentiment remains a key concern," the RBI said, adding:
"Accordingly, even as the policy stance emphasises addressing the growth risks, the headroom for further monetary easing remains quite limited."
The RBI welcomed the government's commitment to fiscal consolidation, noting that the deficit to GDP ratio for 2012/13 fiscal year, which ends in March, was contained around the budgeted level of 5.2 percent and expected to decline to 4.8 percent next year and 3.0 percent in 2016/17.
Expansion of India's Gross Domestic Product in the third quarter of 2012/13 of 4.5 percent was the weakest in the last 15 quarters, with the RBI saying it was worrisome that the services sector - the mainstay of growth - had decelerated to its slowest pace in a decade.
And there are several risks to the global outlook, including the impact of fiscal cuts in the United States and risks to determined policy actions in advanced economies with a significant risk of spillovers to emerging economies. While global inflationary pressures are likely to be subdued, some emerging markets could face elevated energy prices.
India's economic growth for 2012/13 is expected at 5 percent, the slowest growth in a decade, and below the RBI's forecast of 5.5 percent.
The key to reinvigorating growth, the RBI said, was to accelerate investment and "the government has a critical rose to play in this regard by remaining committed to fiscal consolidation, easing the supply bottlenecks and improving governance surrounding project implementation."
India's inflation rate as measured by wholesale prices, the main inflation gauge, rose slightly to an annual rate of 6.84 percent in February from January's 6.62 percent, above the RBI's comfort level of 5 percent.
"However, the unrelenting rise in food inflation is keeping headline wholesale price inflation above the threshold level and consumer price inflation in double digits," the bank said, adding that there are latent pressures from administered prices and this is complicating the task of managing inflation and "underscores the imperative of addressing supply side constraints."
"The foremost challenge for returning the economy to a high growth trajectory is to revive investment. A competitive interest rate is necessary for this, but not sufficient. Sufficiency conditions include bridging the supply constraints, staying the course on fiscal consolidation, both in terms of quantity and quality, and improving governance," the RBI added.