MUMBAI (Reuters) - India's central bank left interest rates unchanged on Tuesday as it supports a battered rupee but said it will roll back recent liquidity tightening measures when stability returns to the currency market, enabling it to resume supporting growth.
While bond markets cheered, the rupee resumed its decline as some investors worried that India will struggle to defend the currency without increasing rates or further tightening liquidity.
As expected, the Reserve Bank of India left its policy repo rate at 7.25 percent but struck a dovish tone as it cut its growth forecast for Asia's third-largest economy to 5.5 percent for the fiscal year, from 5.7 percent previously.
It held bank's cash reserve ratio at a record low of 4.00 percent.
The RBI said liquidity tightening steps taken two weeks ago to defend the rupee "will be rolled back in a calibrated manner as stability is restored to the foreign exchange market, enabling monetary policy to revert to supporting growth with continuing vigil on inflation."
While the benchmark 10-year bond yield dropped as much as 13 basis points to 8.03 percent, the rupee extended its falls to 59.83 per dollar from 59.55 before the decision, putting it close to its level when the RBI implemented emergency measures on July 15.
"Markets will test the RBI again - we are going to test 60 soon - and possibly this will provoke new RBI measures," said Dariusz Kowalczyk, senior economist ex-Japan Asia, Credit Agricole CIB, Hong Kong. "The Bank's credibility is at stake now that it is targeting primarily the currency."
The rupee fell to a record low 61.21 to the dollar on July 8, when it was down about 10 percent since the start of 2013.
Many economists expect the rupee to remain under pressure until New Delhi finds ways to attract inflows. India is weighing options including an overseas bond issue and increasing interest rates on deposits held by non-resident Indians (NRIs).
"I do not think the RBI will reverse the current tightening steps (while) the rupee remains around the 60 to a dollar level. Only the issue of NRI bonds or an extended period of loosening from the Fed can reverse the rupee's fortunes," said Anjali Verma, economist at PhilipCapital in Mumbai.
The last policy statement of RBI Governor Duvvuri Subbarao's five-year tenure, unless it is extended, repeated a call on the government to take urgent steps to bring down a current account deficit that hit a record 4.8 percent of GDP in the last fiscal year.
"It should be emphasized that the time available now should be used with alacrity to institute structural measures to bring the CAD down to sustainable levels," Subbarao said.
However, New Delhi has struggled to implement measures to attract foreign corporate investment, and with elections due by May, Prime Minister Manmohan Singh's weak coalition government has limited room for pushing through further reforms.
The current account gap makes India especially vulnerable as global investors move away from emerging markets in anticipation of a winding down of loose U.S. monetary policy.
"Most external vulnerability indicators have deteriorated, eroding the economy's resilience to shocks," Subbarao said.
Turkey, Brazil and Indonesia have all raised rates to counter capital outflows.
Indian policymakers will be hoping the U.S. Federal Reserve doesn't spark a fresh surge in flows away from emerging markets when it holds its policy review this week.
While India has succeeded in stabilizing the rupee, the surge in short-term interest rates has squeezed funding for corporate borrowers and prompted many economists to cut their growth forecasts.
"India is currently caught in a classic 'impossible trinity' trilemma whereby we are having to forfeit some monetary policy discretion to address external sector concerns," Subbarao said.
India grew at 5 percent in the fiscal year that ended in March, its weakest in a decade, which had prompted the RBI to cut rates by 125 basis points since last year, although it paused in June amid worries of high consumer price inflation.
It said it aims to keep headline wholesale price index inflation at around 5 percent by the end of the fiscal year in March and 3 percent over the medium term. Annual wholesale inflation rose slightly to about 4.9 percent in June.
(This story was corrected to remove extraneous word in second paragraph)