Oct. 27 (Bloomberg) -- India’s central bank took the first step toward withdrawing its record monetary stimulus as inflation pressures build, ordering lenders to keep more cash in government bonds.

Governor Duvvuri Subbarao increased the statutory liquidity ratio to 25 percent from 24 percent after raising the inflation forecast to 6.5 percent from 5 percent, according to a statement in Mumbai today. The central bank kept benchmark policy rates unchanged, while maintaining an economic growth estimate for the year ending March 31 at 6 percent, “with an upward bias.”

The rupee pared losses and stocks declined after the statement spurred speculation the Reserve Bank of India will boost borrowing costs by year-end. Today’s shift also signals intensifying global concern about consumer and asset-price increases, with Norway tomorrow forecast to follow Australia in raising rates this month.

“The balance of judgment at the current juncture is that it may be appropriate to sequence the ‘exit’ in a calibrated way,” Subbarao said in the statement. The move will ensure “that while the recovery process is not hampered, inflation expectations remain anchored,” he said.

Subbarao, who has injected 5.85 trillion rupees ($130 billion) of cash since September 2008 to protect the Indian economy from the worst financial crisis since the 1930s, said draining that money has become a “central issue in our policy matrix.” The liquidity injection was the equivalent to almost 9 percent of India’s gross domestic product, Asia’s third-largest.

Timing an Increase

“This move points to an imminent interest rate action,” said Ramya Suryanarayanan, an economist at DBS Group Holdings Ltd. in Singapore. “Inflation pressures are building up.”

The rupee pared its loss to 0.4 percent, trading at 46.84 per dollar at 12:30 p.m. local time after reaching 46.9450 earlier. The Bombay Stock Exchange’s Sensitive index fell 1.5 percent to 16489.81.

The central bank said “unconventional” steps taken during the global meltdown in the past year can now be reversed to damp price gains, adding that reversing the “conventional measures is not considered appropriate for now.”

Subbarao maintained the reverse repurchase rate at 3.25 percent, the repurchase rate at 4.75 percent and the cash reserve ratio at 5 percent, in line with the median forecast of 24 economists surveyed by Bloomberg News.

Bad Loans

The central bank cut the refinance limit to exporters to 15 percent of their eligible outstanding credit from 50 percent, and asked lenders to set aside more funds as provision for loans to property companies.

India becomes the second country, after Australia, among Group of 20 nations to take steps to boost borrowing costs, underscoring a rising threat of accelerating consumer and asset prices. At the same time, today’s decision risks damping a recovery from India’s weakest growth pace in six years.

Subbarao said today’s action wouldn’t affect the “liquidity position” of the banking system, since most commercial banks have government bond holdings amounting to 27.6 percent of their deposits.

Central banks globally have stepped up their vigil against inflation and asset-price increases.

Global Context

The Reserve Bank of Australia increased rates three weeks ago, citing costlier real estate. Norway’s Norges Bank is set to raise borrowing costs tomorrow, according to a Bloomberg survey. Bank of Korea Governor Lee Seong Tae said Oct. 23 that keeping rates at a record low may not be healthy for the economy.

At the U.S. Federal Reserve, officials under Chairman Ben S. Bernanke are reviewing whether recent gains in asset prices and narrowing credit spreads are justified as they try to ensure near- zero borrowing costs don’t create bubbles.

Subbarao said there are “definitive” indications that India’s economy is recovering. Accordingly, attention around the world has shifted from “managing the crisis to managing the recovery.” He said the prospects for Indian industry have become “more promising” and with the revival in the stock market and international financial markets, there will be a pick-up in investments.

The decision to signal tighter monetary conditions comes after Finance Minister Pranab Mukherjee told Bloomberg-UTV television channel on Oct. 8 that promoting economic growth and containing inflation are both important and the central bank shouldn’t “compromise” one for the other.

Weak Monsoon

Subbarao is concerned about consumer-price inflation in India that’s running above 10 percent and may accelerate further after the weakest monsoon rains since 1972 create food shortages. India’s $1.2 trillion economy depends on the June to September rains to water crops.

India uses wholesale price data as its key inflation gauge; consumer price indexes are calculated on the basis of rural and urban workers and don’t capture the aggregate price picture.

Wholesale prices rose for a sixth week on Oct. 10, gaining 1.21 percent. Robert Prior-Wandesforde, an economist at HSBC Group Plc in Singapore, expects the rate to hit 8 percent by March 31. Asset prices are also rising, evidenced by the 75 percent climb in the Bombay Stock Exchange’s Sensitive index since January.

“The central bank faces a very delicate situation to manage growth and inflation,” said Ravi Sud, chief financial officer at Hero Honda Motors Ltd., India’s biggest motorcycle maker. “On balance, inflation is the risk as it will hurt consumption and eventually hurt growth as well.”

It will be a “big challenge” to sustain Hero Honda’s profit margins because of rising commodity prices, Sud said last week. Hero Honda, based in New Delhi, is the Indian affiliate of Japan’s Honda Motor Co.

To contact the reporters on this story: Cherian Thomas in Mumbai at Cthomas1@bloomberg.net

Last Updated: October 27, 2009 03:25 EDT