The Reserve Bank of India (RBI) is not expected to cut interest rates at its review on Tuesday as it remains worried about inflation, but it may cut the cash reserve ratio (CRR) for banks as a way to relieve tight liquidity, a move that would cheer markets as a sign of easing intent.

Economists polled by Reuters last week were unanimous in their view that the Reserve Bank of India will keep rates on hold this week, despite weakening economic growth.

A minority -- 7 out of 20 -- forecast that the RBI would cut the CRR, the proportion of deposits that banks must hold with the central bank, by 25 or 50 basis points from 6 percent, where it has stood since April 2010.

"Liquidity tightness is persisting and it is getting far too uncomfortable. More importantly, it has not eased after the open market operations," said Shubhada Rao, chief economist at Yes Bank, referring to bond buybacks by the central bank.

A cut in the CRR would ease banking system liquidity tha has been far tighter than the RBI's target of 1 percent surplus or deficit in terms of aggregate deposits.

On Monday, banks borrowed 1.42 trillion rupees from the RBI's repo window, more than double the 600 billion rupees that would indicate a deficit of 1 per cent.

Anjali Verma, an economist at MF Global, said the yield on the benchmark 10-year government bond could fall 2 or 3 basis points from 8.19 per cent now if the RBI cuts the CRR.

Verma, who expects a CRR cut on Tuesday, said the yield could rise to 8.25-8.30 per cent if the RBI leaves the CRR on hold.

"It is liquidity tightness, also the fact that growth is slowing down, and inflation is going to fall further going ahead, which builds a case for a CRR cut," she said.

However, RBI Deputy Governor Subir Gokarn has indicated a reluctance to cut the CRR, noting that the central bank views it as a monetary policy signal as well as a liquidity tool.

Data last week showed annual headline inflation, as measured by the wholesale price index, slowed to a two-year low of 7.47 per cent in December. But manufactured products inflation edged up from the previous month.

Non-food manufacturing, or core, inflation is particularly sticky. Also, factory output rose 5.9 per cent in November from a year earlier, exceeding all forecasts and providing a glimmer of optimism for the economy that the RBI is likely to take into account when making its policy decision, analysts said.

Still, nearly all economists who were polled expect the bank to cut its policy repo rate by June, after increasing it 13 times between March 2010 and October 2011.

The rate now stands at 8.5 per cent.

HAWKISH STANCE
With core inflation still high even as falling food prices bring down headline inflation, many RBI-watchers believe the central bank will refrain from cutting the CRR right away.

Goldman Sachs, however, rates the probability of a 25-basis-point CRR cut on Tuesday at 60 per cent, noting that tight liquidity effectively pushes up rates and pointing out the slow pace of monetary policy transmission in India.

"With the long lags in the system, there is a need to start the easing process early to help investor and corporate confidence to kick-start the recovery in 2H2012," Goldman Sachs economist Tushar Poddar wrote in a note on Monday.

Goldman Sachs expects the RBI to cut its 7.5 per cent economic growth forecast for the fiscal year that ends in March, as well as its headline inflation forecast for March.

"With a potential set of forecasts which call for lower growth and inflation compared to its earlier projections, the RBI would need to signal a change in stance," Goldman said.

The market will scour the bank's quarterly macroeconomic report at 5 pm on Monday for clues on what to expect on Tuesday. While the review is mostly backward-looking, the tone of the comments will be critical.

A Reuters poll last week forecast annual Indian GDP growth of 7 per cent in the current fiscal year, far below the 8.5 per cent of a year earlier.

The RBI, which held to its hawkish stance long after other major central banks shifted their focus towards lifting growth, left rates on hold at its last review in mid-December but sent a strong signal that its next move would be to ease policy.