Ananth Narayan, MD, regional head, fixed income, currencies and commodities, South Asia, Standard Chartered Bank, believes that yields on the benchmark bond are likely to stay above 8.25% given the expected supply of government paper. Narayan tells Shobhana Subramanian that while the rupee will remain stable in the near term, the country does need to address issues such as slowing growth and the high fiscal deficits. Excerpts:

The bond markets have taken the news of the additional R40,000 crore of government borrowings pretty well…

Yes, to some extent it had been pencilled in, especially after the experience of October when the government first announced additional borrowings and the market was weak. Having said that, there were factors that compensated; inflation is expected to trend down to around 7.5% in December and perhaps lower in January. That would give RBI room to change its monetary stance from one of managing inflation to giving a fillip to growth. If RBI, therefore, starts to cut rates and eases liquidity by cutting CRR that would provide some support to the bond markets.

What if the RBI doesn?t cut rates or the CRR before March because inflationary pressures persist?

Yes, it?s a tough decision for RBI because IIP came in at a negative 5% for October and clearly capex is down dramatically. Can RBI therefore give greater weightage to growth, given inflation is trending down, by cutting rates in January? It is a possibility. The Street is not expecting a rate cut right away but there is an outside chance they may consider both a rate cut and a CRR cut.

Also, for the bond markets, the series of OMOs has been a supporting factor; given liquidity is on the tighter side, with an average of R1 lakh crore being borrowed in the LAF, it would necessitate more OMO buying. They?ve indicated they intend to manage liquidity; the currency in circulation increasing and with the government needing more money, there is a visible shortfall.

So where do see the yield on the benchmark bond?

The easing of the monetary stance will happen either in January or March and that should ease up short-end rates. So, the LAF corridor should move south from 7.5-8.5%. We reckon there could be a 100 basis points of rate cuts in 2012. Having said that, given that there is supply of governemnt bonds to contend with, it should keep a floor on the yields.

We have R1,16,000 crore of issuances plus some T-Bill issuances with some support from OMOs for about R45,000 crore at best. So, it is difficult to see yields coming down dramatically but yields for the duration between one to five years could come down and we?re already seeing that one year yields are at 8.10%. The ten-year yield would struggle to come down below 8.25% but the curve could get steep substantially with the one year coming down to 7.5%, unlike last year.

Are the FIIs investing in the debt markets?

Sebi data indicates that since the start of December approximately R25,000 crore worth of FII investments have happened. So one estimates that $3 billion might have come into government bonds and $2 billion into corporate bonds of the new quotas.

Hence, we assume around $5 billion is still left to come in with probably R10,000 crore to come into the gilts market. FII investments add to the pool of money and there?s the ancillary benefit of bringing in foreign currency into the system.

Where is the rupee headed?

Fortunately, the haemorrhaging has stopped thanks to the RBI?s actions and the rupee should trade between 52.50 and 53.50. So, we have time to address the core issues. But the time that RBI buys has to be used by the system to sort out underlying weaknesses in terms of growth, external debt and so on. The short-term component of debt, for instance, is larger than RBI would like.

There are solutions and we need to implement them. The big issue plaguing us is the lack of capital flows, so we need to bring growth back on the radar. In a funny way, RBI changing its monetary stance would aid growth; normally lower interest rates weaken the currency but in this case it could be different.

Is there FII appetite for Indian debt?

There is foreign appetite for debt but when we speak to FIIs they say they need to see consistency in the policies. Sebi has put some restrictions on selling bonds in a bid to curb churning and possibly because it wants long-term players pension funds and so on. Also, we do need to sort out issues to ensure that the India growth story stays on track. Of late, we seem to have become somewhat complacent.