MUMBAI: India’s central bank Governor Duvvuri Subbarao said economic growth is "gaining momentum" after he told lenders to set aside more deposits as reserves than economists predicted to check inflation.

Subbarao increased the cash reserve ratio to 5.75 percent from 5 percent, exceeding the median forecast for a half-point move in a Bloomberg News survey, a statement from the Reserve Bank of India showed in Mumbai today. The central bank kept benchmark interest rates unchanged.

The decision is India’s biggest step yet toward raising borrowing costs as inflation and asset-bubble concerns reverberate across Asia. China, Malaysia and the Philippines moved closer to increasing rates this month and Australia and Vietnam have already done so, spurring a sell-off in stocks and bolstering the outlook for currency gains in the region.

"The policy is indicating a sequential step toward monetary tightening in India," said Shubhada Rao, chief economist at Yes Bank in Mumbai. “The bank may raise policy rates before the next scheduled meeting” on April 20, the economist said.

India’s benchmark stock index gained, reversing earlier declines, after the central bank estimated the $1.2 trillion economy, Asia’s third largest, will expand 7.5 percent in the year ending March 31, more than its October forecast of 6 percent “with an upward bias.”

The Sensitive stock index rose 0.3 percent to 16,357.96 in Mumbai today. The yield on 10-year government bonds gained 4 basis points to 7.59 percent while the rupee weakened to as low as 46.39 against the dollar from 46.36 before the report.

Supply Pressure

"Inflation pressures currently stem from the supply side, but there is a risk of that spilling over into a wider inflationary process as economic recovery sustains," Subbarao said in a press conference in Mumbai after the monetary policy decision.

The central bank raised its inflation forecast to 8.5 percent by March 31 from 6.5 percent.

“The message being sent across is that stern steps will be taken going forward to contain inflation,” said Killol Pandya, who oversees the equivalent of $152 million in Indian debt at Shinsei Asset Management India in Mumbai.

In China, the central bank ordered some banks to pare lending, raised the ratio for deposits banks must set aside as reserves and guided bill yields higher this month after loan growth surged.

Equities Retreat

Malaysia kept borrowing costs unchanged on Jan. 26, while warning that rates cannot be kept “too low” for too long because of the need to prevent a build-up of "financial imbalances." The Philippines increased its so-called rediscounting rate, one of the interest rates it charges lenders for borrowing money from the central bank.

Equities have retreated on concern that the withdrawal of stimulus measures will slow a rebound in corporate earnings. The MSCI Asia Pacific index has lost more than 6 percent in the past two weeks.

Analysts anticipate currency gains as strengthening economies force central banks to act. The rupee may gain almost 8 percent by year-end to 43 per dollar, according to the median forecast in Bloomberg survey. China’s yuan and Malaysia’s ringgit are estimated to advance 3.7 percent.

India’s central bank left its benchmark reverse repurchase rate unchanged at 3.25 percent and the repurchase rate at 4.75 percent, according to today’s statement. The increase in cash reserves will drain 360 billion rupees ($7.8 billion) from the banking system in two stages, on Feb. 13 and Feb. 27.

Excess Liquidity

"As growth accelerates and the output gap closes, excess liquidity, if allowed to persist, may exacerbate inflation expectations," Subbarao said in the monetary policy statement.

India’s benchmark wholesale-price inflation accelerated to 7.3 percent in December, the fastest pace since November 2008. Food accounted for 80 percent of December’s inflation reading, government data showed, as deficient rains last year hurt output of rice, wheat and sugar.

Manufacturing inflation surged to 5.2 percent in December from 1.6 percent in October. Industrial production rose 11.7 percent in November, the fastest pace in two years, as sales at companies including Hero Honda Motors surged.

Hero Honda, the nation’s biggest motorcycle maker, reported a better-than-estimated 79 percent increase in third-quarter net income after sales climbed.

Demand Pressures

"Tighter monetary policy will have no impact on inflation as it is largely a supply-side-driven phenomenon," Harsh Pati Singhania, president of the Federation of Indian Chambers of Commerce and Industry in New Delhi, said before the report. "Interest rates should not be increased."

Subbarao said there have been "some signs" of demand pressures on inflation and that he expects the current growth rate of 7.5 percent to continue in the next financial year starting April 1.

To ease supply constraints, the government on Jan. 13 announced plans to sell as much as 3 million metric tons of wheat and rice in the open market until March and permit duty- free imports of white sugar until Dec. 31 to increase supplies.

Prime Minister Manmohan Singh’s government is under pressure to tame inflation as opposition parties stepped up their criticism of his administration for failing to curb price gains. Inflation is politically sensitive in India, where the World Bank estimates almost three-quarters of the nation’s 1.2 billion people live on less than $2 a day.

Subbarao said the withdrawal of monetary accommodation can’t be "effective" in controlling inflation unless the fiscal stimulus is also rolled-back in a coordinated manner. He said government borrowing must be cut to contain inflation and to meet credit demand from companies.

QUICK TAKES
Raises cash reserve ratio by 75 bps to 5.75%
Keeps reverse repo, repo rates unchanged
CRR hike to absorb Rs 36,000 cr of liquidity
CRR increase to be effective in 2 stages
First CRR hike of 50 bps effective from Feb 13
Second CRR hike of 25 bps effective from Feb 27
Reduction in excess liquidity to anchor inflation
Raises FY10 inflation estimate to 8.5% vs 6.5% in October
Ups FY10 GDP estimate to 7.5% vs 6% earlier
Expect Oct-Dec GDP growth to be lower vs Apr-Jun
Lowers FY10 credit growth target to 16% vs 18%
Cuts money supply growth estimate to 16.5%
Inflation expected to moderate from July 2010
Potential rise in oil prices can stoke inflation
Stance shifted to managing recovery vs managing crisis
Need for specific steps for fiscal consolidation
Higher taxes cut in spending to control fiscal deficit

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