July 31 (Bloomberg) -- India's central bank aims to reverse expansionary monetary measures if the government commits itself to fiscal discipline and the economy recovers, Governor Duvvuri Subbarao said in New Delhi today.
"Reversing the expansionary policies is definitely on the agenda on the way forward," he said. "For this to happen, there are two necessary conditions. The government will have to show a firm and credible commitment to fiscal responsibility. Second, there will have to be more definite signs of recovery."
Subbarao this week left the central bank's reverse repurchase rate unchanged at 3.25 percent and maintained the repurchase rate at 4.75 percent after cutting them by a quarter point each on April 21.
"The counter-cyclical spending by the government and the accommodative monetary policy were both necessary in order to cushion the economy from the onslaught of the crisis," the governor said today. "Nevertheless, the sudden and rapid expansion of the government borrowing program has impeded monetary transmission."
The central bank raised its inflation forecast for the year to March 31 to around 5 percent from an April estimate of 4 percent and said it may soon need to "reverse" the loose monetary policy of the past 10 months.
"The government borrowing resulted in firming up of yields, notwithstanding the substantial excess liquidity, militating against the low-interest-rate regime that we want," the governor said today.
Finance Minister Pranab Mukherjee on July 6 announced plans to borrow a record 4.51 trillion rupees ($94 billion) to fund spending on roads, power and aid for the poor.
The budget shortfall is forecast at 6.8 percent of GDP in the year to March 2010.
The government's higher deficit may lead to inflation.
"On the monetary side, the increased fiscal deficit is going to pose more than a proportionate challenge," Subbarao said today. The "creation of high-power money in the face of large fiscal deficits even if there is no direct primary financing is not cost-less; it can sow the seeds of the next inflationary cycle."
The challenge for the central bank is to maintain a comfortable liquidity situation while at the same time anchoring inflation expectations, the governor said today. Inflation targeting is not practical in India, he said.
India's benchmark wholesale-price index declined 1.54 percent in the week to July 18, the seventh straight weekly drop. Prices retreated 1.61 percent in the first week of June, the biggest drop since December 1978, according to central bank data.
The central bank will maintain "an accommodative monetary stance until there are definite and robust signs of recovery," Subbarao said in this week's quarterly policy statement. India's economy may grow "6 percent with an upward bias" in the year to March 2010, according to the bank.
India's $1.2 trillion economy, the third largest in Asia, expanded 6.7 percent in the year to March 2009. That compares with average growth of 8.5 percent in the previous five years.
"The uncertain monsoon outlook could further accentuate food-price inflation," according to the central bank. Monsoon rainfall in India, the main source of irrigation for the nation's 235 million farmers, was 19 percent below average as of July 22, Farm Minister Sharad Pawar said July 28.
Insufficient rain has caused acreage of all major crops to lag behind year-ago levels, denting prospects for bigger harvests of rice, oilseeds and sugar cane. India, the world's second-biggest rice producer, planted monsoon paddy crops in 28 percent less area this year because of scant rain in the nation's main growing regions, according to Pawar.
"The challenge for the RBI is to maintain a comfortable liquidity situation while at the same time anchoring inflation expectations," Subbarao said.
To contact the reporter on this story: Kartik Goyal in New Delhi at email@example.com .