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Why India Should Not Follow China in Cutting Rates

Friday, 8 Jun 2012 | 7:27 AM ET

After a surprise interest rate cut by China, all eyes are now on another Asian economic powerhouse, India, which is also expected to cut rates to boost flagging growth when its central bank meets in over a week’s time.

Passers by are reflected on the logo of the Reserve Bank of India (RBI) outside its headquarters in Mumbai on January 29, 2010. India's central bank kept interest rates on hold Friday but moved to drain liquidity from the banking system in a bid to tame surging inflation without hurting economic recovery. The Reserve Bank of India (RBI) boosted its cash reserve ratio -- the sum commercial banks keep on deposit -- by a higher-than-expected 75 basis points to 5.75 percent in what it said was a bi
Pal Pillai|AFP|Getty Images
Passers by are reflected on the logo of the Reserve Bank of India (RBI) outside its headquarters in Mumbai on January 29, 2010. India's central bank kept interest rates on hold Friday but moved to drain liquidity from the banking system in a bid to tame surging inflation without hurting economic recovery. The Reserve Bank of India (RBI) boosted its cash reserve ratio -- the sum commercial banks keep on deposit -- by a higher-than-expected 75 basis points to 5.75 percent in what it said was a bi

But one expert warns against such monetary easing as it would fan inflation, which shows little sign of decelerating in India.

“Inflation risks are still high. The Reserve Bank of India can risk raising inflation (further) by cutting rates, when prices are (already) at an elevated level,” Taimur Baig, Chief Economist, Global Markets Research at Deutsche Bank wrote in a note titled 'RBI Should Not Be Cutting Rates on June 18, But Would It Anyway?'

The market consensus is for a 25-50 basis point rate cut on top of April’s 0.5 percent cut as economic growth slowed to a nine-year low of 5.3 percent in the first quarter of the year.

In contrast, China's economy slowed in the first quarter to 8.1 percent and it's inflation rate has also eased, falling to 3.4 percent in April. But slowing GDP expansion in India has had little impact on reining in prices.

Baig says that latest PMI (purchasing managers index) indicators have pointed towards rising cost pressures. For example, the May HSBC Services PMI showed input prices grew at their fastest pace in five months. He adds that headline inflation, which accelerated to 7.2 percent in April, touched 7.6 percent in May and could reach 8 percent by July-August.

Even core inflation – that excludes food and energy – though under 5 percent could move higher once the impact of a weaker rupee is fully passed on to consumers by Indian businesses, he said.

Case for Growth

But despite inflationary pressures, Robert Prior-Wandesforde, Director of Asian Economics at Credit Suisse, argues the case for growth. “The shocking first quarter GDP print suggests that the RBI needs to apply more attention to growth relative to inflation.”

He adds that, “We can carry on blaming the government and it hasn’t done (enough to boost the economy) but that doesn't mean the RBI shouldn’t help out as well.” Prior-Wandesforde expects a 25 basis point cut at the upcoming policy meeting.

This week, market expectations of a rate cut rose after RBI Deputy Governor Subir Gokarn suggested Monday that easing core inflation and sluggish growth offer the central bank a window to ease policy stance.

By CNBC's Ansuya Harjani

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