The central bank also kept the cash reserve ratio (CRR), or the percentage of deposits that banks have to keep with RBI, unchanged at 4.75 per cent.
"The policy action today will anchor inflation expectation," RBI governor D Subbarao said on Tuesday while announcing the policy stance. He said the spike in inflation to 7.2 per cent in June 2012 was due to high food inflation.
RBI, like all central banks, has the job to control inflation in the economy. Subbarao said that while large global and emerging economies are slowing down and witnessing a fall in inflation, India is an outlier.
"India is an outlier. The economic growth is slowing but inflation is still high. Lowering rates will aggravate inflation and may not stimulate growth," he added.
He assured markets that RBI would respond to any shocks swiftly. "RBI stands ready to act swiftly to withstand global shocks," he said.
The cut in SLR by 1 per cent to 23 per cent will give banks an incentive to buy government bonds. RBI has raised a concern about the rising government fiscal deficit.
"At current levels of the CAD and the fiscal deficit, the Indian economy faces the “twin deficit” risk. Financing the latter from domestic saving crowds out private investment, thus lowering growth prospects," Subbarao said in his statement.
This clearly highlights RBI's concern that an increase in the government borrowing could hurt RBI's ability to stimulate growth. The cut in SLR will ensure that banks have enough money to lend to the government through purchase of government bonds without cutting any lending to major sectors that need money to stimulate growth.
RBI has cut the growth forecast to 6.5 per cent for 2012-13 from 7.3 per cent earlier. "Growth forecast was lowered due to deficient monsoon, weak industrial output and increased global risks," Subbarao said.
The stock market reacted to RBI's concerns over growth and inflation outlook. The 30-share BSE Sensex fell over 60 points or 0.6 per cent after the policy announcement while Nifty also slipped into negative territory after staying relatively flat before the announcement. Bank stocks fell sharply. The BSE Bankex fell 1.1 per cent.
"The Reserve Bank of India struck a hawkish stance in its monetary policy statement," said Anubhuti Sahay, economist at Standard Chartered Bank. "Once again, containing inflation and inflationary expectations have been highlighted as the priority," Sahay added.
"Today's action was no more a surprise for the market. Further cutting down the SLR would have little impact on the overall systemic liquidity and would negatively weigh on the government securities market in the near term," Shakty Satapaty, fixed income strategist, A K Capital, Mumbai said.
Public sector banks have a large exposure to government securities or bonds. Any negative impact on these investments could hurt profits.
A Thomson Reuters poll of 20 economists had earlier forecast that the central bank would leave its repo rate unchanged.
India’s June headline inflation, as measured by the Wholesale Price Index, was at 7.25 per cent, a number that RBI Governor Duvurri Subbarao had earlier dubbed as being way above the “threshold level”.
In its macroeconomic review of the June quarter released on Monday, the central bank had revised its headline inflation rate for fiscal 2013 upwards to 7.3 per cent from 6.9 per cent.
It pointed out that while a weak monsoon may not directly impact the growth number, below-normal rains could have a effect on inflation and income. A poor monsoon would also have fiscal impact for the economy, the central bank said, particularly if the government decides to announce drought relief measures, the Mahatma Gandhi National Rural Employment Act, and other welfare programmes.
It also called for “decisive policy action backed by credible commitment to a long-term strategy for correcting macroeconomic imbalances and stimulating investment”, saying this was crucial to reviving confidence as well as providing space for monetary policy to help sustain growth while keeping inflation under control.
The RBI, which said it "frontloaded" rate cutting in April with a steep 50 basis point drop, has stressed the need for the government to reduce its fiscal deficit and said high interest rates were not the key reason for slowing economy.
India’s growth has been slowing, and hit a nine-year low of 5.3 per cent in the March quarter, partly because of a global slowdown as well as weaker demand and investment activity at home.