Central Banks

India's central bank cuts key rate by 50 BPs to 6.75%

Neelabh Chaturvedi

The Reserve Bank of India surprised markets Tuesday by slashing its key interest rate by 0.50 percentage points to 6.75%, taking advantage of easing inflation to boost growth in an economy that hasn't been able to escape global headwinds.

A Reuters poll last week showed only one out of 51 economists had expected a 50 basis points cut in the repo rate, while 45 had expected a 25 bps cut.

The RBI had previously cut interest rates three times this year, lowering it by 25 basis points each time.

Read MoreCommodities collapse a catch-22 for India

So what prompted the RBI to cut rates this aggressively?

Runaway inflation in the past has toppled governments in India, but lower prices of commodities such as crude oil, of which India is a large importer, have helped calm inflation.

"Headline consumer price index (CPI) inflation reached its lowest level in August since November 2014. The ebbing of inflation in the year so far is due to a combination of low month-on-month increases in prices and favorable base effects," the RBI said.

The knock-on effect of the recent depreciation of the rupee will have to be carefully monitored, although benign crude prices should have an offsetting effect, the RBI noted. Taking all this into consideration, inflation is expected to reach 5.8 per cent in January 2016, the central bank estimates.

Wholesale prices meanwhile have been falling more sharply, in line with the deflationary trend in other parts of the world including China.

India's one of the world's fastest-growing major economies although activity has slowed. The slowdown in China as well as market ructions are a clear risk.

"With global growth and trade slower than initial expectations, a continuing lack of appetite for new investment in the private sector, the constraint imposed by stressed assets on bank lending and waning business confidence, output growth projected for 2015-16 is marked down slightly to 7.4 per cent from 7.6 per cent earlier," the RBI said.

Growth in the manufacturing sector has been patchy in recent years, a departure from the years leading up to the debt crisis when factories making cars and household appliances were humming. While manufacturing surveys remain in expansion territory, there has been some easing given the uncertainty overseas.

"Since our last review, however, external demand conditions have turned weaker, suggesting a more persistent drag from lower exports and cheaper imports due to global overcapacity. This contributes to continuing domestic capacity under-utilisation, decelerating new orders and a rising ratio of finished goods inventories to sales," the RBI said.

The 'not-so-exciting' part of India's growth story
The 'not-so-exciting' part of India's growth story

India relies less on exports for driving its economy than many of its Asian peers, but stuttering growth in major markets has dented demand for goods and services produced by Indian firms. There have been some benefits from lower commodity prices but the gains in the price reduction have been offset by importers buying higher volumes.

"With services exports moderating, the widening of the merchandise trade deficit could lead to a modest increase in the current account deficit," the RBI said.

--Reuters contributed to this article