India raises interest rates to cool economy

Central bank acts to reduce inflation of 10 per cent as economic growth surges in Asia's third-largest economy

While recession and fears of a "double dip" downturn dominate economic news in the West, the emerging economies of the East are encountering increasing problems with their rapidly expanding and overheating economies.

Yesterday it was the turn of India to impose a tighter monetary policy to deal with inflation just short of 10 per cent. The Reserve Bank of India (RBI) raised its key policy rates by 25 basis points each, as expected, and also lifted its cash reserve ratio requirement for banks by a quarter of a percentage point to drain liquidity from the financial system.

The governor of the Reserve Bank, Duvvuri Subbarao, said: "With the recovery now firmly in place, we need to move in a calibrated manner in the direction of normalising our policy instruments." The official benchmark "reverse repo" rate has been raised to 3.75 per cent. India joins China and the commodity-driven economies of Norway and Australia in raising rates.

In its post-meeting statement, the Reserve Bank explicitly stated that "debt management considerations warrant supportive liquidity conditions". It has now raised its benchmark rates by 50 basis points since the start of this year.

Continuing the economic revolution that has brought India back into the global economy, Asia's third-largest economy is forecast to grow by 8.5 per cent this year and 9 per cent in 2011, driven by services as well as high-profile manufacturing success stories such as Tata. Among the larger emerging nations, only China is growing more strongly, and there, too, an inflationary burst seems to be developing, in their case in urban real estate.

In India annual inflation reached 9.9 per cent in March, its fastest pace in 17 months. Agriculture is still recovering from the monsoon that caused widespread shortages of staples last year and global commodity prices have also fed through to the economy. Fiscal policy has also been allowed to support the Indian economy, with the government scheduled to borrow a record 4.57 trillion rupees (£60bn) this year.

Observers believe that the central bank will continue increasing interest rates through the year to bring inflation down. A repo rate of 6.25 per cent is anticipated by the year end.

"At this point it looks like we have to move many times," Mr Subbarao added. "Everything need not be done in one step and we believe that moving in several baby steps towards normalisation is better for the economy to adjust to pre-crisis growth levels."

Out of the control of the authorities, the monsoon season later this year will also be crucial. A repeat of last year's unusual weather would be doubly unwelcome, as it would probably serve to reinforce already high inflationary expectations, a key factor in managing monetary policy in all economies.

Compared with Western nations, food accounts for a much larger proportion of inflation in India. Although the latest official forecast is for a normal season, a survey of private sector forecasters earlier this week showed that some expect that weather conditions may be "erratic" in May and June and possibly delay the planting of some crops. Nick Chamie, the head of emerging markets research at RBC, said: "Although the Reserve Bank's rhetoric retains a hawkish tone, policymakers clearly believe that small, steady moves are appropriate for now, perhaps reflecting what appears to be a relatively benign assessment of the inflation outlook.

"We expect, however, price pressures will remain strong in the months ahead and could surprise RBI to the upside."

Inflation is an especially sensitive political issue in India, where not all of the population has greatly benefited from globalisation and rapid growth. The World Bank estimates that three-quarters of the 1.2 billion people live on less than $2 a day. The Prime Minister, Manmohan Singh, has been criticised by opposition parties and has promised to bring inflation under control soon.

The World Bank has said that faster economic growth has seen rising disparities between urban and rural areas in India, prosperous and lagging states, and skilled and low-skilled workers. India's richest states have incomes that are five times higher than those of the poorest states – a gap that is higher than in most other democratic countries, and may damage social cohesion.