By Swati Bhat and Shamik Paul
MUMBAI (Reuters) - Investors in India's rocketing bond market are betting heavily on the Reserve Bank of India (RBI) shedding some of its habitual caution by both cutting interest rates and injecting liquidity, but some analysts reckon hopes for further easing are becoming overblown.
Following a suprisingly benign inflation reading for April and what investors interpreted as unexpectedly dovish comments from RBI Governor Duvvuri Subbarao last week, benchmark bond yields have plunged to their lowest since December 2009.
With annual wholesale price inflation dropping below 5 percent and into the central bank's comfort zone for the first time in more than three years, the market expects the RBI to cut its policy repo rate, currently set at 7.25 percent, by a quarter point for a fourth time this year at a policy review on June 17.
It is also expected to carry out open market operations to redress an acute liquidity shortage that partly explains why banks have failed to lower lending rates to companies and consumers by more than they have done, despite the cuts in official rates.
These expectations have translated into a more than 40 basis point fall in ten-year bond yields so far this month, which, if there is no late reversal, would give the market its biggest monthly gain in three years.
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But high expectations carry a risk of deep disappointment.
"If the RBI doesn't deliver on these expectations, there is likely to be some sell-off," said Bekxy Kuriakose, head of fixed income at Principal PNB Asset Management. "There doesn't seem to be any reason why RBI shouldn't cut, given the data."
The greater uncertainty appears to hang over how much debt the central bank will be willing to buy through OMOs.
"I don't see the RBI cutting rates and injecting large doses of liquidity at the same time," said a fund manager at a domestic investment house who declined to be identified.
"It is not a very aggressive central bank. And the situation definitely does not warrant such an action."
Consumer price inflation, running at over 9 percent, will have to come down, and India's high fiscal and current account deficits will need to improve before Subbarao is likely to feel comfortable taking aggressive easing measures.
GRAPHIC: India's repo rate vs banks' rates: https://bsmedia.business-standard.comlink.reuters.com/mar28t
GRAPHIC: Bank's daily repo borrowings: http://link.reuters.com/rar28t
GRAPHIC: India's CPI vs WPI: http://link.reuters.com/zar28t
FILLING THE GAP
After each rate cut this year, the RBI has warned that the scope for further easing was limited.
Yet, when Subbarao said on May 14 that he would take falling inflation into account when making decisions on interest rates, investors seized on the remark to set off on a bull run.
"The markets are fundamentally treating every comment by the RBI as a change in stance," said Rupa Rege Nitsure, chief economist at Bank of Baroda. "But RBI is clearly saying that there is no change in stance and inflation considerations are still on its radar."
The RBI is expected to add liquidity to fill some of the shortfall caused by government reluctance to spend, as New Delhi tries to contain its fiscal deficit. The question is by how much. Nitsure doubted whether the RBI would resort to aggressive OMOs, and she does not expect the repo rate to be cut at next month's policy review.
Ideally, bankers want the RBI to reduce the cash reserve ratio (CRR), or the amount of cash deposits banks must keep at the central bank, to improve their lending power. But at 4.0 percent, it is already at its lowest in three decades, giving little room to bring it down further.
"The scope for further reduction in the CRR is very, very limited," said a senior RBI official, who declined to be identified.
Markets are pricing in at least 200-300 billion rupees worth of OMOs before the end of June, betting the central bank will need to inject liquidity to avoid cutting interest rates again to no effect.
Reflecting the tight liquidity, banks' borrowing from the RBI's repo window has regularly surged to around 1 trillion rupees this month, well above the central bank's comfort zone of around 650 billion rupees.
The government has parked around one trillion rupees at the RBI as of March, roughly twice the amount normally held there, although some analysts say that has come down to around 600-700 billion rupees. The RBI does not disclose the actual balances.
Getting that money into circulation is critical to restoring liquidity since government spending contributes about 11 percent of India's gross domestic product.
Most analysts expect this money to be spent in the lead-up to general elections due by next May, in order to curry favour with voters. But an economy expected to have grown in the last fiscal year at its slowest pace in a decade, needs money faster, putting the onus on the RBI. But it can only do so much.
"RBI will try to keep liquidity comfortable via OMOs or a partial CRR cut. But they will carry out OMOs only to a certain extent," said Bank of Baroda's Nitsure. "Because of still high consumer price inflation and high current account deficit, OMOs cannot continue on a sustained basis."
(Editing by Rafael Nam and Simon Cameron-Moore)