By Abhishek Vishnoi
MUMBAI (Reuters) - The BSE Sensex fell 1.4 percent on Monday, the biggest percentage fall since June 1, led by a selloff in lenders after the RBI unexpectedly kept both interest rates and the cash reserve ratio unchanged.
The decision threatens to cut short a rally this month that had sent local shares to a six-week high early on Monday. The gains had been fuelled by hopes the Reserve Bank of India would ease monetary policy after recent data showed economic growth in January-March fell to a nine-year low.
After the close of markets Fitch Ratings cut India's sovereign outlook to "negative" from "stable", saying growth potential would "deteriorate" unless the country implements structural reforms, and citing "limited progress" on fiscal consolidation.
(Read: Fitch cuts India rating outlook to negative, click http://in.reuters.com/article/2012/06/18/fitch-india-outlook-revision-idINDEE85H0A020120618)
Local shares could see gains further erode should the global risk environment worsen, with a narrow victory by pro-bailout parties in Greece on Sunday having a muted impact because of persistent worries about Spanish and Italian debt problems.
Global investor attention will also shift to the Federal Reserve meeting ending on Wednesday to see whether it takes action to shore up the U.S. economy.
"Flows in the market will be determined by events such as Fed meeting and Europe," said C. J. George, managing director at Geojit BNP Paribas.
"If rupee improves then there will be significant inflows. Till then, market will remain sideways,"
The main BSE index fell 1.4 percent, after erasing earlier gains of as much as 0.9 percent that had brought the index to its highest since May 4.
NSE's 50-share Nifty fell 1.5 percent.
The RBI surprised investors by leaving monetary policy unchanged, citing continued concerns about inflation, after last cutting the repo rate by 50 basis points in April.
(Read: Rates on hold as growth crumbles, click http://in.reuters.com/article/2012/06/18/india-rbi-repo-rate-crr-idINDEE85H04M20120618)
The focus now also shifts to the government, whose perceived lack of policy reform was a key factor behind the slump in local markets that sent the rupee currency tumbling to a record low in May.
Fitch made the stakes clear by cutting India's outlook, in a repeat of Standard & Poor's action in April, leaving the country under threat of losing its investment-grade rating from both agencies.
"Rates are headed lower, but cuts are going to be more unpredictable," said Sandeep J. Shah, CEO of investment advisory firm Sampriti Capital.
"Expectations from the government are at zero, and any significant action would therefore result in short-covering."
The surprise RBI outcome sent the NSE banking index tumbling down 3.3 percent after the sub-index had gained 6.6 percent this month as of Friday's close.
However, broader losses could be contained after the RBI also stated it would monitor liquidity conditions, such as by purchasing bonds via open market operations as warranted.
State Bank of India dropped 4.4 percent, while ICICI Bank fell 3.5 percent.
Other rate-sensitive stocks also slumped, with property firm DLF down 4.7 percent and Unitech down 3 percent.
Auto makers fell, too, with Tata Motors ending down 1 percent on dashed hopes lower interest rates would cut financing costs for purchasing new vehicles.
However, Tata Group companies Tinplate Company of India
Tinplate surged 18.9 percent, while Tata Sponge Iron rallied 12.6 percent.
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(Additional reporting by Manoj Dharra; Editing by Rafael Nam)