India's central bank held its policy rate and cash reserve ratio (CRR) steady and warned the recent fall in the rupee could fuel inflation and it was ready to use "all available instruments and measures to respond rapidly and appropriately to any adverse developments."
The Reserve Bank of India (RBI), which was faced with a rapid drop in its currency last week - along with other emerging markets - acknowledged that inflation had eased but food inflation remained high and warned that "upside pressures on the way forward from the pass-through of rupee depreciation, recent increases in administered prices and persisting imbalances, especially relating to food, pose risks of second-round effects."
India's annual wholesale price inflation, the country's main inflation gauge, eased to 4.7 percent in May from 4.89 percent in April for the lowest rate since November 2009. All categories in the index fell except for food, which is sustaining the upside pressure on inflation, the RBI said.
Retail price inflation fell to 9.3 percent in May from an average of 10.2 percent in fiscal 2012/13. The RBI does not have a formal inflation target but is aiming for inflation of 5 percent by March 2014.
"Given that food inflation remains high, the inflation outlook will be influenced by concerted efforts to break food inflation persistence," the RBI said, adding that the outlook would be affected by "suppressed inflation being released through revisions in administered prices, including the minimum support prices (MSP) as well as the recent depreciation of the rupee."
Following the recent decline in the rupee, economists had expected the RBI to keep its policy rate steady at 7.25 percent but many had expected the central bank to cut the CRR, which determines the proportion of deposits that banks have to keep in cash at the RBI, to stimulate growth.
The RBI has cut its policy rate three times this year by a total of 75 basis points and last cut the CRR by 25 basis points in January.
The RBI said its policy stance would be determined by the path of economic growth, inflation and the balance of payments situation in the months ahead.
"It is only a durable receding of inflation that will open up the space for monetary policy to continue to address risks to growth," the RBI said.
Although several measures have been taken to contain the current account deficit, the RBI said it had to be vigilant about the current "global uncertainty, the rapid shift in risk perceptions and its impact on capital flows."
Most emerging markets have faced pressure on their currencies and domestic markets since late May when investors started to prepare for an expected reduction in asset purchases by the U.S. by reducing their holdings of emerging market assets.
India is especially vulnerable to the effect of an outflow of capital due to its high current account deficit (CAD) which widened to $32.6 billion in the fourth quarter of 2012, equivalent to 6.7 percent of Gross Domestic Product.
The CAD is expected to narrow in the current 2013/14 financial year due to softer global commodity prices and recent measures to dampen gold imports, the RBI said, adding the main challenge is to reduce its to a sustainable level so it can be financed through stable capital flows.
An improvement in the government deficit and its commitment to keep the fiscal deficit for 2013/14 at 4.8 percent from 4.9 percent for 2012/13 should have a favourable impact on investor confidence.
India's rupee has been depreciating since July 2011 but stabilized in the first few months of this year, trading around 55 rupees to the U.S. dollar. But since the beginning of May, the rupee has fallen rapidly and hit a record low of 58.98 to the dollar last Tuesday before recovering after dealers reported intervention in the market by the RBI.
From May 22 - when Federal Reserve Chairman Ben Bernanke said asset purchases could be reduced "in the next few meetings" of the Fed - to June 11, the rupee fell by 6.6 percent "due to sell-off by foreign institutional investors, reflecting risk-off sentiment triggered by apprehensions of possible tapering of quantitative easing by the U.S. Fed," the RBI said.
Last week the Finance ministry's chief economic adviser, Raghruram Rajan was also quoted as saying that India's government and the RBI would take action to ease the sharp fall in the rupee.
"As recent experience has shown, shifts in global market sentiment can trigger sudden stop and reversal of capital from a broad swath of emerging economies, swiftly amplifying risks to the outlook. India is not an exception," the RBI said.
The RBI also said that global economic activity had slowed since its last statement in May and risks remain elevated.
Economic conditions in India also remain weak, hamstrung by infrastructure bottlenecks, supply constraints, lacklustre domestic demand and subdued investment sentiment, the RBI said.
India's Gross Domestic Product expanded by 4.8 percent in the first quarter of 2013, up from 4.7 percent in the fourth quarter of 2012.
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