India's central bank cut interest rates on Tuesday for the first time in three years by an unexpectedly sharp 50 basis points to give a boost to flagging economic growth but warned that there is limited scope for further rate cuts.

The Reserve Bank of India cut its policy repo rate  to 8.00 percent, compared with expectations for a 25 basis point cut in a Reuters poll.

It also warned that India's current account deficit, which widened to 4.3 percent of GDP in the December quarter, is "unsustainable" and will be difficult to finance given projections of lower capital flows to emerging markets in 2012.

India's economy grew at 6.1 percent in the December quarter, its slowest in almost three years, but the central bank had been reluctant to begin cutting rates as inflation remained elevated, and RBI Governor Duvvuri Subbarao maintained a cautious view in his Tuesday policy statement.

"It must be emphasised that the deviation of growth from its trend is modest. At the same time, upside risks to inflation persist. These considerations inherently limit the space for further reduction in policy rates," he said.

The RBI raised rates 13 times between March 2010 and October 2011 as it struggled to contain price pressures. On Monday, the headline wholesale price index  eased slightly to 6.89 percent for March but was still above expectations, as a drop in manufacturing inflation was offset by a surge in food inflation.

On Tuesday, the RBI left unchanged the cash reserve ratio (CRR), the share of deposits that banks must hold with the central bank, at 4.75 percent, in line with expectations, after cutting it by 125 basis points since January to ease tight market liquidity.

Subbarao said liquidity conditions are moving towards normal after several months of acute shortage of cash in the banking system, but also said the RBI would take "appropriate and proactive" steps if needed to restore liquidity to comfortable levels.

The central bank said its baseline expectation for GDP growth in the fiscal year that ends in March 2013 is 7.3 percent, compared with an expected 6.9 percent in the just-completed year. It expects headline inflation to end the year at 6.5 percent, with little deviation expected during the year.

Sluggish capital investment has exacerbated bottlenecks in the Indian economy, bringing down its capacity for non-inflationary growth to an estimated 7 percent, from 8.5 percent before the global financial crisis. Supply shortages persist in infrastructure, energy, minerals and skilled labour.

"A strategy to increase the economy's potential by focusing on these constraints is an imperative," Subbarao said. He also reiterated the need for the government to cap a subsidy burden, which led to a bloating of the fiscal deficit in the recent fiscal year to 5.9 percent of GDP.

A weakened government has been unwilling to pass along the price of higher global oil prices to end-users, but pressure on the fiscal deficit is expected to force it to do so. "From the perspective of vulnerabilities emerging from the fiscal and current account deficits, it is imperative for macroeconomic stability that administered prices of petroleum products are increased to reflect their true costs of production," he said. - Reuters