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NEW DELHI (Reuters) - The Reserve Bank of India left interest rates on hold and warned of resurgent inflation risks, putting pressure on the government to trim the fiscal deficit a day before the federal budget is announced.
But a political backlash against the already weakened government's move to raise railway fares for the first time in eight years may further undermine its ability to tame populist spending or enact reforms to jump-start the economy.
"Given the coalition government's position, I would be quite skeptical of any meaningful reforms coming out of the budget," said Ashish Vaidya, executive director and head of interest rates at UBS in Mumbai.
The Reserve Bank of India has said progress on deficit reduction is a key condition for cutting interest rates.
"The RBI is fighting a lone battle, and ideally, it would be extremely positive if the government were to respond with policy initiatives," Vaidya said.
Bond yields and swap rates rose and stocks fell after the central bank kept its policy repo rate on hold at 8.50 percent. A rate cut that many had expected at the central bank's April 17 review - which would be the first since the aftermath of the global financial crisis - is now seen as less likely.
The Trinamool Congress Party, a key ally of the Congress party's fractious ruling coalition, called for the resignation of Railway Minister Dinesh Trivedi, who is from the same party, and a rollback in the fare increase announced on Wednesday.
Trivedi had not resigned as of Thursday evening, following a chaotic day in parliament.
Prime Minister Manmohan Singh's Congress coalition was already weakened after a drubbing in recent state polls and more than a year of corruption scandals and policy paralysis that has deterred investment and curbed growth momentum.
"None of this augurs well for the upcoming general budget," the Times of India said in an editorial on Thursday after Trinamool leader Mamata Banerjee, who is chief minister in the state of West Bengal and was previously railway minister, spearheaded opposition to the fare increase.
"There'll be misgivings about Mamata playing to the gallery by bashing any reform the finance minister proposes in the budget. So he might think it better to play safe than sorry," the newspaper said.
Finance Minister Pranab Mukherjee will present the federal budget to parliament on Friday and is under pressure from investors to lay out a realistic plan to reduce a fiscal deficit that is on track to bulge past 6 percent of GDP in the current fiscal year, from a target of 4.6 percent.
He is expected to set a target in the range of 4.8-5.3 percent of GDP for the year from April, helped by improved economic growth, tax increases, slowing growth in subsidy expenditure and an increase in the sale of state assets.
Growth in Asia's third largest economy slowed to 6.1 percent in the three months to December, the weakest in almost three years, and is on track to fall just short of 7 percent in the fiscal year that ends this month. Heavy government borrowing and spending is blamed for pushing up interest rates, crowding out corporate borrowing and fuelling inflation.
A finance ministry report on Thursday said growth could accelerate to 7.6 percent in the coming fiscal year.
J. Moses Harding, head of the asset liabilities committee at IndusInd Bank, said resistance within India's ruling coalition to Wednesday's rail fare increase may have prompted RBI Governor Duvvuri Subbarao to adopt a cautious stance.
"The ability of the FM (finance minister) to manage the fiscal deficit within acceptable levels is in doubt," he said. "The RBI has affirmed the need to cut rates, but no clear indication on its timing and magnitude. The fear is that of delay beyond April."
The RBI's tougher-than-expected stance on inflation disappointed investors clamoring for a cut in borrowing costs.
"Upside risks to inflation have increased from the recent surge in oil prices, fiscal slippage and rupee depreciation," it said in its mid-quarter policy statement, adding that future actions will be towards lowering rates but refraining from giving a timeframe.
Brokerage Nomura lowered its forecast for rate cuts in 2012 to 75 basis points from 100 bps.
The RBI has said it will be constrained from cutting rates in the absence of credible fiscal consolidation.
"A rate cut in April depends on what the government budget delivers. If it is deemed expansionary/inflationary then chances of a ...cut are reduced," said Jonathan Cavenagh, FX strategist at Westpac in Singapore.
India's headline inflation picked up for the first time in five months in February, to 6.95 percent, on higher food costs but another measure of price pressures cooled, sparking market talk that a rate cut might be in the offing.
"Notwithstanding the deceleration in growth, inflation risks remain which will influence both the timing and magnitude of future rate actions," the RBI said.
Additional reporting by Archana Narayanan, Suvahsree Dey Choudhury and Neha Dasgupta in Mumbai; Editing by John Stonestreet