India starts to tighten monetary policy

India’s central bank took its first steps on Tuesday to unwind the ultra-loose monetary policy adopted during the global financial crisis, a further sign of the strengthening recovery across regional economies.

The Reserve Bank of India announced that local banks would have to boost their reserves, partly through the purchase of government bonds, in an effort to withdraw liquidity from the system and ward off the renewed inflation threat.

The move, which triggered a sell-off on the Bombay Stock Exchange, prepares the ground for an interest rate rise early next year as Asia’s third biggest economy shows increasing signs of shrugging off the downturn.

Australia raised rates earlier this month, the only Group of 20 economy to do so. South Korea is expected to tighten monetary policy in coming months as its economy strengthens.

Duvvuri Subbarao, RBI governor, left the repo rate, a key lending rate unchanged at 4.75 per cent on Tuesday, but sharply lifted provisioning requirements for bank loans to property companies and to cover non-performing assets.

The RBI also pushed up the requirement for banks to hold at least 25 per cent of their deposits in government securities from 24 per cent.

The governor’s statement had a more hawkish edge than at previous rate setting meetings during his year-long time in office, highlighting the bank’s concerns about price stability as inflation creeps up.

The RBI now expects the Wholesale Price Index, India’s key inflation gauge, to rise to 6.5 per cent by the end of March from a forecast of 5 per cent.

“In India, there are definitive indications of the economy attaining the ‘escape velocity’ and reverting to the growth track,” Mr Subbarao said. “The performance of the industrial sector has improved markedly in recent months.”

Tushar Poddar, economist at Goldman Sachs in Mumbai, said the ending of special support measures introduced during the crisis was “the first phase of the RBI’s exit from loose policy”.

The RBI is constrained by the ruling Congress party’s wish to maintain a loose policy stance to allow a strategy that favours growth over inflation. The government has put considerable store in returning to growth of 9 per cent, resulting in the biggest fiscal deficit in 20 years.

The prime minister’s advisory panel last week predicted 6.5 per cent growth this fiscal year and said it saw no reason for a monetary policy change. Economists predict a change in direction next year.

Robert Prior-Wandesforde, a senior Asian economist at HSBC, said the RBI had joined policy authorities in Singapore, Hong Kong and South Korea in taking pre-emptive steps to cool the property market before bubbles developed.

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