Budget 2013: Will Subbaro take Chidambaram's cue on fiscal deficit

Finance Minister P. Chidambaram has cleared the decks for the Reserve Bank of India (RBI) to cut interest rates by reining in India's hefty fiscal deficit . But will RBI Governor D. Subbarao take the cue and reduce rates to stimulate growth in Asia's third-largest economy?

Markets have been on edge since Subbarao told a G20 summit in Moscow two weeks ago the RBI would be closely watching the fiscal deficit number. "We will look at the headline fiscal deficit number but also look at the quality of the fiscal adjustment," he said. Since then, all eyes had been on the 2013/14 Budget to see how Chidambaram planned to rein in the fiscal deficit.  Investors got some comfort on Thursday when the annual Budget lowered the next financial year's fiscal deficit target to 4.8 per cent of GDP and restricted the 2012/13 number at 5.2 percent.

Investors are delighted that despite a shortfall in revenues, the finance minister has managed to rein in the fiscal deficit which was widely expected to reach 5.3 per cent. This is probably because of tight control on the expenditure side last year. Former Finance Minister Pranab Mukherjee had pegged the 2012/13 fiscal deficit at 5.1 per cent, while Chidamabaram had pledged it would not go beyond 5.3 per cent when he took over the finance minister's job last year.

Despite the fiscal deficit numbers, the central bank may still face an interest rate dilemma because inflation isn't under control yet. The RBI was under pressure to reduce rates for months to revive the flagging economy, but its hands were tied with inflation at alarmingly high levels. It finally cut the key policy rate for the first time in nine months in January, but with inflation still a concern it may not have room to cut rates at its next policy meeting.

In January this year, the RBI cut the policy or repo rate, which is the rate at which the central bank lends funds to banks, by 25 basis points to 7.75 percent. The reduction came after the wholesale price index (WPI) eased to 7.18 per cent in December 2012. However, the consumer price index (CPI) remains a concern, with food prices still putting pressure on inflation in India. Trapped between inflation and slowing growth, the central's decision will not be easy.