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India Takes the Right Step by Holding Rates, Say Pros

The Indian central bank’s surprise decision Monday to hold interest rates steady may have sent the stock market and rupee falling, but analysts tell CNBC the Reserve Bank of India did the right thing.

Felix Hug | Photolibrary RM | Getty Images

The RBI was widely expected to cut the benchmark rate - currently at 8 percent - by another 25 basis points on top of the half percentage point cut in April, as growth slowed to a nine-year low of 5.3 percent in the first quarter of the year. But this time around, inflation concerns outweighed worries over slowing economic momentum.

India’s Former Finance Secretary S Narayan told CNBC that ramping up liquidity via interest rate cuts is “dangerous” for the economy as it could cause prices to rise even further.

“Inflation is (present in India) because demand continues to grow, whereas supply (remains) low. By providing more liquidity you are going to push up the demand even more, which means that instead of getting growth you would get higher inflation,” Narayan said.

The Wholesale Price Index (WPI) rose for the second consecutive month in May to 7.5 percent from 7.2 percent. Weak monsoon rains so far this season, which could dampen agricultural output, is also raising worries over that food prices will go higher in coming months.

Leif Eskesen, Chief India Economist at HSBC agrees that stepping up liquidity would have negative implications for the economy. “If you lower the policy rates, and support the demand side, but you don’t take steps to improve the supply side, you could tease up inflation,” Eskesen said.

Rajeev Malik, Senior Economist at CLSA Asia-Pacific Markets says India’s growth problems cannot be fixed by the central bank cutting rates. Instead, he said the government must implement structural reforms to spur investment.

“India’s problems can’t be fixed by the RBI. It has to require New Delhi to get into action,” Malik said.

“India is a bit like a truck that is losing speed, not because it doesn’t have fuel, but because the gear box is not working, adding more fuel is not going to make it go faster,” he added.

The government has been baffling investors with several policy flip-flops. Last year the government cleared and then stalled foreign direct investment in multibrand retailing and in May postponed by a year the implementation of new rules cracking down on tax avoidance.

According to Eskesen the government must initiate policy changes like cutting foreign investment restrictions, overhaul the tax structure and improve infrastructure if it wants to revive investments into the country.

According to both Eskesen and Narayan supply-side reforms in India such as developing infrastructure and ensuring power availability are the most urgent steps needed to curb inflation and support growth.

“When you have power outages, for example, it limits the amount the industrial sector can produce. There’s enough demand, but not enough supply,” Eskesen added.

By CNBC's Ansuya Harjani

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