Investors are betting Indian bonds are set for their biggest rally since the global financial crisis, wagering that a government at risk of losing its investment-grade rating will put fiscal discipline ahead of election largess.
The key date is February 28, when the 2013/14 budget is unveiled. If Finance Minister Palaniappan Chidambaram announces a net borrowing figure of 5 trillion rupees ($93 billion) or less for the year starting April 1, analysts say a 30 basis point drop in yields over the past two months could triple this year.
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"Our base-case scenario is a rally in Indian bonds in 2013/14," said Rohit Arora, emerging market rate strategist at Barclays Capital. He expects the benchmark 10-year bond yield to fall to 7.25 percent this year, from above 7.80 percent currently.
Others also see the yield at 7.25 percent. If realized, the yield would be down 90 points since late December, the biggest fall since the 10-year yield plunged more than 250 basis points after the collapse of Lehman Brothers in 2008.
Analysts came to a net borrowing figure of around 5 trillion rupee by allowing for 950 billion rupees in debt redemptions due in the next fiscal year and factoring in an ambitious fiscal deficit target of 4.8 percent.
Disappointment with the budget would leave bonds vulnerable to a sell-off, and put the onus back on the Reserve Bank of India (RBI) to support the debt market, including through bond purchases.
"If the net borrowing is above 5 trillion rupees, the market will not be in too much of a hurry to buy bonds," said Vivek Rajpal, rates strategist at Nomura in Mumbai.
"Yields will inch up and market will be dependent on the RBI's open market operations."
Junk Rating Risk
Optimism the government can limit the increase in net borrowing to about 5 trillion rupees is at odds with history -since 2006/07, net borrowing has risen by an average of 28 percent a year - and more so as it is the main platform to introduce major spending programs ahead of elections in 2014.
For example in 2008, Chidambaram, in a previous stint as finance minister, included a 600 billion rupees ($11 billion) farm loan waiver scheme in his budget as the government looked to shore up support ahead of the 2009 elections.
"The market has typically been highly skeptical of the government being able to meet its targets, and most of the time that skepticism has been warranted," said Kenneth Akintewe, portfolio manager at Aberdeen Asset Management Asia.
Both Fitch Ratings and Standard & Poor's cut India's credit ratings outlook to "negative" last year, criticizing fiscal policy. The risk of a cut to "junk", which would raise the cost of borrowing, seems to have caught the government's attention.
Chidambaram has pledged India will not breach its fiscal deficit targets, and has followed through with unpopular measures to signal he means what he says, including allowing state retailers to set diesel prices and slashing spending.
As a result, the government has an estimated cash balance of more than 1 trillion rupees, a critical cushion even if it were to increase spending later this year.
"We would like to give the government the benefit of doubt and reiterate that the FY14 budget will see the finance minister walk the tightrope adroitly between the need for welfare and the urgent quest for fiscal consolidation," Deutsche Bank analysts said in a report.
Stand and Deliver
The fall in bond yields already seen has been spurred by a combination of the faith in the government's fiscal discipline - which would cut the supply of bonds - and on expectations that official interest rates will fall this year.
Indeed, wholesale inflation fell to a three-year low of 6.62 percent in January, and the RBI cut its policy interest rate on January 29.
But the RBI's cautious outlook and previous criticism of fiscal policy has analysts thinking it is waiting to see the government's budget plans before acting more aggressively.
That makes the budget an important set-piece for a market that has priced in Chidambaram delivering on his promises.
"We think softening inflation and RBI's growth-supportive monetary policy are key positives for bonds. With the finance minister committed to fiscal consolidation, government's attempts to limit its market borrowing will also support bonds," said Nagaraj Kulkarni, South Asia senior rates strategist at Standard Chartered Bank in Singapore.