Introduction
Following its recent decision in increasing diesel prices designed to cut a budget deficit swollen by energy subsidies, as well as counter the threat of becoming the first of the BRICs economies to be downgraded to junk, India’s central bank unexpectedly reduced the amount of deposits lenders must set aside as reserves, supporting the government's push to revive growth even as it kept interest rates unchanged to damp elevated inflation.

India Cuts Reserve Ratio to Boost Growth
On 17 September 2012, Governor Duvvuri Subbarao cut the cash reserve ratio to 4.5% from 4.75%, effective 22 September 2012, adding about INR170.0bln (USD3.12bln) to the banking system. The central bank kept the benchmark repurchase rate at 8.0%, leaving it unchanged for a third meeting as expected. The cut in the cash reserve ratio was hailed by bankers who hinted that it could trigger a reduction in lending rates in the coming days.

According to the Reserve Bank of India (RBI), the “primary focus” remains the containment of price pressures. Currently, inflation and India’s fiscal and current-account shortfalls constrain a stronger monetary policy response to growth risks. “The government's recent actions have paved the way for a more favourable growth-inflation dynamic,” the central bank said. “Several challenges remain, one of which is persistent inflation. But, as policy actions to stimulate growth materialize, monetary policy will reinforce the positive impact of these actions while maintaining its focus on inflation management.”

RBI’s decision comes after Asian nations such as the Philippines, Indonesia, Malaysia and South Korea held rates this month. Officials are evaluating the impact of the US Federal Reserve’s decision on 13 September 2012 to embark on a third round of bond purchases to boost growth and employment. The reserve-ratio cut is a “small but welcome” measure, Finance Minister Palaniappan Chidambaram commented of the Reserve Bank’s decision. He said he is confident the central bank's review on 30 October 2012 will be far more supportive of growth as the government is expected to make further policy changes and lay out a path to fiscal correction.

India: Cash Reserve Ratio
         (January 2000- 18 September 2012) India: Key Policy Rates
(January 2008- 18 September 2012)
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Source: Bloomberg, KFHR Source: Bloomberg, KFHR

Current Economic Scenario and Budget Deficit Woes
After years of high growth, India is now running into more turbulent weather. GDP eased significantly to 5.3% y-o-y in 1Q12 (April-June 2012) from 6.1% y-o-y in 4Q11, weighed down by a contraction in the manufacturing sector, marking the slowest quarterly expansion in nine years. Breakdown showed that India’s manufacturing sector (which contributes roughly 15.7% of total GDP) declined -0.3% y-o-y in 1Q12 from 0.6% y-o-y in 4Q11 as high raw material costs, public-policy ambivalence, tight monetary conditions and global uncertainty took their toll on the manufacturing sector.

Meanwhile, India's manufacturing activity grew at its slowest pace this year in August 2012 as export orders fell for the second successive month while power shortages disrupted production. The seasonally adjusted measure, prepared by Markit, fell to 52.8 in August 2012 from 52.9 in July 2012. A figure above 50 indicates expansion. The weak growth in the manufacturing sector reflects a worrying slowdown in the overall economy even as inflation remains persistently high, complicating the central bank's task of supporting economic growth without allowing price pressures to intensify.

India: Quarterly GDP Growth Trend
(1Q07-1Q12) India: Industrial Production Trend
(January 2007- July 2012)
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Source: Bloomberg, KFHR Source: Bloomberg, KFHR

In addition, India’s industrial production index (IPI) grew close to nil at 0.1% y-o-y in July 2012, hurt by weak investment that has become the beleaguered government’s primary concern as it scrambles to revive a flagging economy with little help likely from the central bank in the short-term. The data, released by the Central Statistics Office on 12 September 2012, showed output at factories, mines and utilities grew 0.1% y-o-y. Capital goods output, seen as a key indicator of future investment, slumped 5.0%. The data was more evidence that the problems afflicting Asia’s third largest economy are far from over. GDP has grown 5.5%or less in the last two quarters, a far cry from the 7.0%-8.0%growth seen in the preceding period.

Standard & Poor’s and Fitch Ratings this year cut the India’s sovereign credit outlook to negative, a step closer to non-investment grade rating, citing widening budget deficit. The high cost of imported fuel is partly blamed for the ballooning of India's current-account deficit (the gap between exports and goods and services imports) to its widest level in eight years. Currently, India plans to trim its subsidy bill for food, fuel and fertilizer by 12.0% to INR1.9tln, or 2.0% of GDP, this financial year. Mr. Singh is targeting a budget deficit of 5.1% of GDP in the year ending March 2013 from 5.8% a year earlier.

On 14 September 2012, the Indian government announced a slew of long over-due measures to boost investment and prop up the rupee. These included allowing foreign direct investment (FDI) in broadcast, multi-brand retail and aviation, together with partial privatization of four state-run industries. The central bank said the government's recent actions had paved the way for more favourable economic conditions by initiating a shift in expenditure away from consumption by reducing fuel subsidies and toward investment, including through foreign direct investment. However, we foresee a lag in implementation, as the Indian government has a history of flip-flopping on policies in the face of political pressure. In December 2011, for example, the government unveiled plans for FDI in multiband retailing, only to back away from it days later.

The Current Inflation Background
On the inflation front, it has quickened lately, a climb that may be exacerbated by the first increase in diesel prices in 14 months and a rise in commodities as the U.S. steps up monetary easing. India boosted the subsidised fuel’s tariff last week to pare its fiscal deficit.

The decision by the government of Manmohan Singh trails intense pressure to plug one of the biggest drains on the treasury, arising from the projected USD34.0bln annual cost of fuel subsidies at a time of high world oil prices. It will also help refiners cut revenue losses by about INR203.0bln (USD3.7bln). The long-awaited move was greeted with elation by investors and raised expectations of more reforms to reverse an investment slump and resuscitate a sluggish economy.

In detail, a cabinet committee increased diesel prices by 5 rupees per litre effective 14 September 2012. That translates as a 14.0% rise, including taxes, with diesel at the pump now costing roughly INR47 per litre. The hike is the first in 15 months (first increase was on 25 June 2011). Meanwhile, gasoline and kerosene were left unchanged, however the committee decided to limit the number of subsidized cooking gas cylinders per household to six per year, a move seen as hitting the poor hard. Any LPG cylinders bought over this ceiling will be at market rates, which could almost double the price.

India: Wholesale Prices Index Trend
(January 2009- August 2012)
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Source: Bloomberg, KFHR

There is a reason why inflation is a main concern for India. Driven by high food prices, India's wholesale price index rose 7.6% in August 2012 from 6.87% in July 2012. Higher diesel prices mean higher inflation in the short term, and we expect the hike in fuel price would have a direct impact of 81 basis points on headline WPI inflation. But the central bank has been clear it wants the government to slash the fiscal deficit, a structural inflation driver, before it will tackle rates. Moving forward, we believe headline WPI inflation will continue to remain high in the range of 7.0%-8.0% y-o-y in 2012 as commodity and food prices will remain elevated.

The Reserve Bank of India (RBI) has come under increasing pressure to lower monetary policy rates as growth in Asia's third-largest economy has slowed sharply. However, the RBI has refrained from doing so fearing it might be premature since this year's below-normal rainfall is expected to stoke inflation in the coming months. The RBI held key policy rates steady at the last three policy reviews after lowering it by half-a-percentage point in April 2012. After its cautious move to cut the reserve ratio, we believe that it is the maximum the RBI could do under the current economic circumstances. Therefore, we believe the central bank will keep borrowing costs at the same level until year-end, the highest level amongst major Asian economies, as the likelihood of sticky inflation will further worsen inflationary pressures.

Conclusion
The sharp deceleration in 1Q12 GDP growth has clearly induced concerns pertaining to easing growth rate in 2012. Our assessment of leading indicators of several sectors points at further possible deceleration in growth momentum. Hence, we are revising downwards our 2012 growth projection for India to 6.5%-7.0% y-o-y from earlier forecast of 7.5% y-o-y.
 
Nevertheless, we are still optimistic about India’s strong domestic demand will cushion the negative impact from external conditions, especially the services sector. Robust domestic demand builds the resilience of the services sector which makes up of 60.0% of India’s GDP.