THE Reserve Bank of India (RBI), the country’s central bank, which over the past four-and-a-half years has been relentlessly raising interest rates to curb liquidity in the economy, has done an about turn, triggering off the process of slashing rates.

Buffeted by the global financial turmoil, India has been able to withstand the crisis to some extent, thanks to the rather stern overseeing of the economy by the central bank. But recent weeks have seen the impact of the credit crisis hurt India to some extent.

Worse, Indian stock market indices have nosedived, with foreign institutional investors (FIIs) dumping shares and repatriating huge sums of money. This has had a devastating affect on the Indian currency, which has also tumbled against the dollar and other major currencies.

The Sensex, the benchmark index on the stock markets, has plummeted by more than half; it was hovering around the 20,000-mark in January. Last week, it dipped to a record, four-year-low, plunging below the 9,800-mark. FIIs have pulled out over $12 billion from the stock markets during the first 10 months of the year, as against a record net inflow of nearly $17.5 billion during the same period last year.

The Indian rupee, which was trading at 39.37 to the dollar in January, plunged to 49.85 last Thursday, falling by one full per cent that day. India’s foreign exchange reserves, which peaked at almost $315 billion in May, is now down to around $280 billion.

The impact of the crisis has been felt not just in the financial sector, but even on the overall economy. The RBI last week projected a GDP (gross domestic product) growth rate of 7.7 per cent in the current fiscal (ending March 31, 2009). It had expanded by 7.9 per cent in the second-quarter of the financial year, the slowest quarterly growth rate in over four years.

The Indian economy has been growing at a record average of 8.9 per cent ever since the United Progressive Alliance (UPA) came to power in the middle of 2004. The government was confident the economy would grow at around eight per cent this year; however, this has now been scaled down to 7.5 per cent. Next year, GDP growth is expected to decline further to 6.8 per cent.

In a bid to boost the economy, the RBI has started easing liquidity. It has injected over $20 billion into the economy by lowering the cash reserve ratio (CRR) by 2.5 per cent. It also went in for an unexpected cut in the repurchase (repo) rate by 100 basis points to eight per cent last week, ahead of its mid-year review of the economy.

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THE RBI controls liquidity — draining out excess cash during a boom, or injecting funds when there’s a slowdown – through the CRR, the repo rate (the key short-term lending rate) and the reverse repo rate. When the UPA government came to power in the middle of 2004, the CRR was 4.5 per cent, the repo rate was six per cent and the reverse repo was 4.5 per cent.

By the end of 2004, the RBI had raised the CRR to five per cent and the reverse repo to 4.75 per cent. About three years ago, the repo was raised to 6.25 per cent and the reverse repo to 5.25 per cent.

Since then, the RBI has steadily been raising the interest rates, in a bid to control inflation. Last October, the CRR was seven per cent, the repo rate was 7.75 per cent and the reverse repo six per cent. Rates peaked in July, with both the CRR and the repo touching nine per cent. Prime lending rates are also up at around 14 per cent, as against 12.25 per cent in the beginning of the year.

But with the financial crisis gradually hurting the Indian economy, the RBI began reducing the CRR this month; it dropped from nine to 6.5 per cent, and the repo has declined to eight per cent.

The central bank justified the move to raise interest rates over the past few months, citing inflationary trends. The wholesale price index (WPI) – a broad measure of inflation – jumped from 4.5 per cent in January to a record 12.9 per cent in August (when international oil prices almost touched the $150 a barrel mark). However, with global oil, commodity and food prices on a decline (US crude oil prices dipped to $67 a barrel last week), inflation in India has also started easing.

Last week, inflation had moderated slightly to 11.07 per cent, a four-month low. “Headline inflation is still very high,” says finance minister P. Chidambaram. “But I’m confident that as global crude and commodities prices moderate, it will come down.” The government expects inflation to dip below the 10 per cent mark by the end of this year.

With international oil prices declining sharply, there is already a clamour from politicians to reduce the domestic price of petrol, diesel and kerosene. Elections to about half a dozen states are due to be held next month, while general elections are to be held early next year.

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THE Indian central bank says that it is closely monitoring developments in the global and domestic financial markets and “stands ready to take such pre-emptive action as may be necessary to contain excess volatility in the domestic financial markets.”

Even Prime Minister Manmohan Singh has warned that India was already experiencing “the ripple effects” of the global financial turmoil and urged people to prepare for a temporary slowdown.

According to the RBI, “going forward, financial conditions are likely to remain fragile, constraining global growth prospects... financial stress could remain very high and credit constraints from de-leveraging could be deeper and more protracted than envisaged.” It also notes that massive injection of liquidity into the financial system in the backdrop of severe inflation could lead to moral issue hazards.

Besides lowering interest rates to ease the liquidity crunch, the RBI last week also decided to modify the external commercial borrowing (ECB) policy, allowing corporates to borrow up to $500 million a year for rupee expenditure and/or foreign currency expenditure for permissible end-uses under the automatic route.

The central bank had imposed curbs on ECBs a few months ago, when India’s foreign exchange reserves were soaring, the rupee was strengthening against the dollar and other currencies, and there was the problem of excess liquidity in the economy. It had imposed a cap of $100 million on ECBs and had also stipulated limits on the amount that could be brought into the country.

However, under the amended ECB rules, a borrower has the flexibility to keep the funds offshore in liquid assets, place it with the overseas branches or subsidiaries of Indian brands abroad, or even remit the funds to India for credit to their rupee accounts. But the rupee funds cannot be used for inter-corporate lending, or invested in the capital markets or the real estate sector.

Finance minister Chidambaram is confident that Indian firms will now be encouraged to bring back money, raised abroad, following the easing of the ECB norms. “Many people have told me that they are likely to bring it back to India for rupee expenditure, I hope they will bring it back,” says the minister.

Chidambaram, who met senior public sector bankers last week, is also hopeful that banks would now re-start their lending operations as there is adequate liquidity in the system now, following the cut in CRR and repo rate.

Banks though have still not started reducing their rates, but analysts expect some of the state-owned banks to start cutting interest rates on home loans shortly.