MUMBAI India's central bank lowered its benchmark policy rates by 25 basis points on Tuesday for the second time this year in a bid to help revive growth in Asia's third-largest economy, but warned that the scope for further easing is limited.
The rate cut was overshadowed by a political crisis in the governing coalition when a key ally quit, raising fresh doubts about Prime Minister Manmohan Singh's ability to push through a late burst of reforms and win back investors' confidence.
In its mid-quarter policy review, the Reserve Bank of India lowered its policy repo rate to 7.50 percent as expected, and reduced the reverse repo rate to 6.50 percent.
It also left the cash reserve ratio for banks unchanged at 4.00 percent, in line with expectations.
India's economy is on track to grow at its slowest in a decade at around 5 percent in the fiscal year ending this month, and had been expected to see modest improvement in the coming year.
A recent uptick in headline wholesale inflation, rising food price-driven consumer inflation and a record-high current account deficit limit the RBI's space for monetary easing despite pressure from a government facing elections in 2014.
"Even as the policy stance emphasises addressing the growth risks, the headroom for further monetary easing remains quite limited," the RBI said in its statement.
That caution reinforced market expectations that the RBI, which left rates on hold for nine months before cutting them in January, will only lower them by a further 25 or 50 bps in the fiscal year starting in April.
After an initially muted reaction to the widely expected rate cut, Indian stocks .BSESN and the rupee fell on news that the Dravida Munnetra Kazhagam (DMK) would leave the ruling coalition due to differences over the government's stand on alleged war crimes in Sri Lanka.
The withdrawal leaves Singh's coalition at the mercy of smaller parties which are sceptical of reforms such as landmark land acquisition legislation aimed at boosting investment in infrastructure.
Bond yields rose slightly.
"As the coalition becomes more fractured, and depends on outside support from parties that have a narrow agenda, the very act of policymaking gets diluted," said Abheek Barua, chief economist at HDFC Bank.
The current account deficit hit a record-high 5.4 percent in the September quarter and is expected to end the 2012/13 fiscal year at its highest level ever.
"Although capital inflows, mainly in the form of portfolio investment and debt flows provided adequate financing, the growing vulnerability of the external sector to abrupt shifts in sentiment remains a key concern," the RBI said.
February's wholesale price index rose an annual 6.84 percent, faster than in January, although non-food manufacturing inflation, which the central bank uses to assess demand-driven price pressures, slowed to 3.8 percent, the weakest pace since March 2010.
The central bank said the divergence between wholesale and consumer price inflation was "exacerbating the challenge for monetary management in anchoring inflationary expectations."
"RBI has continued to maintain limited room for monetary easing. I expect another 25-50 basis points of cuts in 2013," Anjali Verma, economist at PhillipCapital in Mumbai.
In the federal budget announced at the end of February, Finance Minister P. Chidambaram said India's fiscal deficit would fall to 5.2 percent of GDP in the current fiscal year and 4.8 percent in the next year, targets intended to help stave off a sovereign credit rating downgrade to "junk" status.
(Editing by Sanjeev Miglani)