Rajan Seen Sacrificing Bond Bulls to Protect Savers' Real Return

Bond investors betting big on interest-rate cuts by the Reserve Bank of India would do well to remind themselves of Governor Raghuram Rajan’s pledge to protect savers.

When the central bank chief last reduced benchmark borrowing costs in September, he underlined the need for an inflation-adjusted return of 1.5 to 2 percentage points. With data Monday forecast to show 5.5 percent inflation in February and real interest rates at the low end of his range, Deutsche Bank AG and Societe Generale SA say there is little room to ease aggressively.

Any disappointment on monetary easing could derail the recent rally in rupee bonds and aggravating an exit of foreign funds after February’s biggest withdrawals in almost two years. Rajan, who reduced the benchmark repurchase rate by 125 basis points in 2015, last year said missing his real-rate target risks eroding the value of deposits for India’s 1.3 billion people and forcing households to buy gold as a store of value.

“Given Rajan’s focus on keeping inflation under check, protecting savers and keeping the rupee stable, it seems he doesn’t have room for any aggressive easing,” said Kunal Kundu, a Bengaluru-based economist at Societe Generale. “There will be pressure on bond yields due to higher supply of bonds and on expectation of very little easing from the central bank,” he said, predicting only a 25-basis point reduction in 2016.

Though the so-called real rate is usually the gap between the policy rate and consumer-price inflation, Rajan’s target is based on the one-year treasury bill Yield , which is currently at 7.19 percent. CPI accelerated to a 17-month high of 5.69 percent in January. The repo rate is at 6.75 percent.

Twelve of 16 economists in a Bloomberg survey last month expected the central bank to lower the repo rate by as much as 50 basis points before the next scheduled meeting on April 5. The poll was conducted on Feb. 29 when Prime Minister Narendra Modi’s federal budget embraced the fiscal discipline sought by the RBI to consider easing further. The February CPI data due later on Monday is the other key indicator Rajan is watching.

Food is India’s biggest enemy in the war on inflation, according to the International Monetary Fund, as Rajan aims to limit CPI to 5 percent by March 2017 and 4 percent a year later. Rising incomes, stagnant crop production growth and poor management of buffer stocks have boosted food prices in the world’s second-most populous nation, according to a new IMF book.

Diminishing returns on financial savings could drive demand for physical assets such as gold, leading to potentially higher imports of bullion. That could jeopardize policy makers’ efforts to narrow the current-account deficit and spur declines in the rupee, which has weakened 1.3 percent this year after capping a fifth straight annual decline in 2015.

IMF Warning

The RBI’s monetary stance is “appropriately tight for achieving near-term inflation objectives,” IMF staff wrote in a separate Jan. 27 report that was published earlier this month. They warned that authorities “should stand ready to raise the policy rate if inflationary pressures gather pace,” estimating inflation will average 5.3 percent in the year starting April 1. Rajan has previously served as chief economist at the lender.

Lack of easing could become another reason to dump Indian bonds for foreign funds, who already seem to be taking the government’s promise of fiscal consolidation with a pinch of salt. Overseas holdings of local sovereign and corporate debt have fallen 22.4 billion rupees so far this month, after slumping 87.6 billion rupees last month.

The outflows continue even as the yield on the benchmark 10-year sovereign notes has fallen 15 basis points to 7.63 percent from Feb. 26, the day before the budget. It will drop to 7.50 percent by end-June, according to the median estimate of 10 fixed-income fund managers and traders in a Bloomberg survey conducted Feb. 29.

“Contrary to many in the market, the RBI doesn’t believe the battle on inflation is over,” said Taimur Baig, Singapore-based chief economist for Asia at Deutsche Bank. “We highly doubt if the RBI would entertain aggressive rate cuts this year.”

--With assistance from Manish Modi To contact the reporter on this story: Kartik Goyal in Mumbai at kgoyal@bloomberg.net. To contact the editors responsible for this story: Garfield Reynolds at greynolds1@bloomberg.net, Shikhar Balwani, Sandy Hendry

By: Kartik Goyal

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