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The Reserve Bank of India cut its key short-term rates by 25 basis points each on Tuesday to shore up faltering growth in the face of the global economic slowdown.

The repo rate, at which the Reserve Bank of India infuses cash into the banking system, will be cut to 4.75 per cent, and the reverse repo rate, at which it absorbs excess cash from banks, will be reduced to 3.25 per cent, effective immediately.

The central bank cut is growth estimate for 2008/09, which ended on March 31, to 6.5 to 6.7 per cent, and forecast growth of around 6 per cent for 2009/10.

It said that managing large government borrowing in 2009/10 in a non-disruptive manner would be a major challenge, and said it would used a mix of monetary and debt management tools to ensure this was done smoothly.

“Large borrowings also militate against the low interest rate environment that the Reserve Bank is trying to maintain to spur investment demand in keeping with the stance of monetary policy,” the central bank said in its policy statement.

The bank rate, used by banks to price long-term loans, remained at 6.0 per cent. Banks’ cash reserve requirements were also left unchanged at 5.0 per cent.

Analysts polled by Reuters were almost evenly split over whether the central bank would cut rates or not. Six out of the 11 analysts polled expected the bank to bring down its lending rate by 25 to 50 basis points. The other five forecast the rate to be held steady.

The RBI has now cut its short-term lending rate by 425 basis points in six steps since Oct. 20 as the global economic crisis has hit Asia’s third-largest economy harder than expected. The central bank said wholesale-priced based inflation was expected to turn negative early in the current fiscal year, but this should not be interpreted as deflation for policy purposes.

It projected WPI inflation would be around 4 per cent at the end of 2009/10.

The central bank said a planned April 2009 review of the policy on foreign banks in India would now not go ahead until there was greater clarity regarding stability, recovery of the global financial system and better global coordination on regulation and supervision.

Banks to consider lowering lending rates in a few days.

Less than a week after third-quarter GDP estimates showed a lower-than-expected 5.3 per cent growth rate, the Reserve Bank of India on Wednesday surprised the market and sent fresh signals to banks to lower lending and deposit rates by pruning the repo rate and the reverse repo rate by 50 basis points each.

The repo rate, or the rate at which RBI lends to banks, has been cut to 5 per cent, while the reverse repo rate, or the rate at which the central bank absorbs liquidity, has been pared to 3.5 per cent. The market had given up hopes of an immediate reduction after the central bank prodded banks last week to lower rates.

Around the time the central bank announced its latest move to boost economic activity, Canara Bank said it would cut interest rates on housing and vehicle loans and domestic term deposits, effective March 11.

Others banks, however, said their asset-liability committees (alcos) would meet over the next few days to examine the cost of funds and then decide whether to reduce lending rates.

“Wednesday’s move is prompted by the fact that inflation is coming down and there is a possibility that the numbers may go down to negative territory in June. We expect the cost of funds to drop in a fortnight. When the cost of funds comes down for us, we will pass on the benefit to borrowers,” said HDFC Vice-Chairman and Managing Director, Keki Mistry.

An Axis Bank executive said that the bank would review its home loan rates soon but did not comment on the prime lending rate.

“This is a signal from RBI to review the rates. Our alco will meet in three or four days to take stock of costs and then decide the issue,” Bank of Maharashtra Chairman and Managing Director Allen C A Pereira said.

“RBI has sought to create conditions conducive to consumption and investment, taking into account global developments and their impact on India: a slowdown in growth on one hand and decline in inflation on other,” said ICICI Bank CEO-designate Chanda Kochhar.

The RBI move is largely a sentiment booster for banks rather than a technical one, as banks already have ample liquidity and hardly borrow from the repo window right now, she added.

A cut in reverse repo rates will discourage banks from parking surplus funds with RBI through the liquidity adjustment facility and encourage them to boost lending to the commercial sector. Over the past three months, RBI has slashed the rate 250 basis points.

With the latest repo rate reduction, the fifth since October 20, the overall cut since the global credit crisis intensified adds up to 400 basis points.

Since September, the central bank has also lowered the cash reserve ratio, or the proportion of deposits that banks set aside, by another 400 basis points to inject Rs 1,60,000 crore into the system. Through the series of measures, RBI has provided Rs 3,88,000 crore of primary liquidity to the system.

Banks have, however, refrained from passing on the entire benefits to borrowers and have reduced lending rates 50 to 200 basis points, with private and foreign banks being reluctant to cut rates.

As a result of banks’ risk aversion that prompted them to park larger sums of money in government securities, the flow of resources to the commercial sector from banks and non-banks fell to Rs 4,98,136 crore between April and February 13, against Rs 6,08,351 crore in the corresponding period of the last year. On a year-on-year basis, non-food credit growth, which rose to 29.4 per cent on October 10, decelerated to 19.7 per cent on February 13.

RBI, while advising banks to “monitor their loan portfolio and take early action, to prevent asset impairment” also asked lenders to appropriately price the risk “and ensure that creditworthy enterprises continue to get funding”.

Overall economic activity has slowed, with the economy projected to grow 7.1 per cent this year, against over 9 per cent during the past three years. Industrial output contracted in December, exports have shrunk for four months in a row and growth in the services sector has slowed.

January 2, 2009: On a review of current global and domestic macroeconomic situation, the Reserve Bank has decided to take the following further measures:

Repo Rate

To reduce the repo rate under the liquidity adjustment facility (LAF) by 100 basis points from 6.5 per cent to 5.5 per cent with immediate effect.

Reverse Repo Rate

To reduce the reverse repo rate under the LAF by 100 basis points from 5.0 per cent to 4.0 per cent with immediate effect.

Cash Reserve Ratio

To reduce the cash reserve ratio (CRR) of scheduled banks by 50 basis points from 5.5 per cent to 5.0 per cent from the fortnight beginning January 17, 2009.

The reduction in the CRR will inject additional liquidity of around Rs. 20,000 crore to the financial system. It is expected that the reduction in the policy interest rates and the CRR will further enable banks to provide credit for productive purposes at appropriate interest rates. The Reserve Bank on its part would continue to maintain a comfortable liquidity position in the system.

Background to announcement of present monetary stimulus by RBI :

The global financial situation continues to be uncertain. Since the official recognition of recession in the US, the UK, the Euro area and Japan, the downside risks to the global economy have increased. Concomitantly, the policy initiatives in the advanced economies are geared towards managing the recession and defusing potentially deflationary trends. The US has reduced the Federal Funds Rate to 0 - 0.25 per cent. Several other advanced and emerging economies such as Japan, Canada, Republic of Korea, Hong Kong and China too have reduced their policy rates.

India’s financial sector has remained resilient even in the face of global financial turmoil that is so deep and pervasive. Our financial markets continue to function in an orderly manner. India’s growth trajectory has, however, been impacted both by the financial crisis and the follow-on global economic downturn. This impact has turned out to be deeper and wider than earlier anticipated. Concurrently, because of global developments coupled with supply and demand management measures at home, inflation is on the decline.

Reflecting these developments, the Reserve Bank has adjusted its policy stance from demand management to arresting the moderation in growth. In particular, the aim of these measures was to augment domestic and forex liquidity and to ensure that credit continues to flow to productive sectors of the economy. Notably, since mid-September 2008, the Reserve Bank has reduced the repo rate under the liquidity adjustment facility (LAF) from 9.0 per cent to 6.5 per cent, reduced the reverse repo rate under the LAF from 6.0 per cent to 5.0 per cent and the cash reserve ratio from 9.0 per cent to 5.5 per cent.