MUMBAI - Doubts over how India will vote in a coming election and fears that the government will overspend persuading people to extend its mandate is keeping investors wary of buying bonds despite the lure of low inflation and possible interest rate cuts.
"There is obviously increasing uncertainty going into the general election and that is making investors generally a bit more cautious," said Leong Lin-Jing, investment manager at Aberdeen Standard Investments in Singapore.
On Friday, the government will unveil an interim budget that is expected to be full of goodies for rural and urban middle class voters. Direct cash transfers to farmers, interest-free loans and income tax cuts might help the ruling Bharatiya Janata Party's chances in a general election that must be held by May.
But pre-election largesse won't reassure investors wanting more commitment to fiscal consolidation. Investors have generally liked Modi's pro-business stance, and his government's earlier fiscal conservatism. And the size of the BJP's parliamentary majority at the last election bred confidence in Modi's ability to deliver on policies.
But the BJP's defeat in state polls last month, and recent opinion polls that show it could be forced to form a coalition with partners who could make it harder to press forward with economic reforms and revert to fiscal prudence.
"It is really about having a stable leadership," said Mitul Kotecha, senior emerging market strategist at TD Securities in Singapore.
"If there is no clear mandate at the elections then implementation of reforms could take a hit and prompt foreign capital outflows from India's bond and equity markets."
And if the opposition Congress Party were to form the next coalition government it could adopt populist measures even more worrying for investors.
Earlier this week, Congress announced plans for a universal basic income scheme to support 300 million poor, which some analysts reckon would cost around 1 trillion Indian rupees ($14 billion)annually, and also potentially ignite inflation.
"The universal basic income scheme or any such fiscal largesse can lead to higher wages and therefore higher core inflation," Maneesh Dangi, head of fixed income at Aditya Birla Sun Life, one of India's largest mutual funds.
The fears of fiscal slippage have already pushed benchmark 10-year bond yields up about 30 basis points during the past six weeks, and some analysts expect them to rise further.
That gloominess comes despite hopes of a more dovish stance on interest rates from the Reserve Bank of India following the appointment last month of a new governor.
Dangi, who manages around $22.5 billion of debt assets, believes the bond market should be even more bearish, as it is probably over-optimistic over chances for an early RBI rate cut. "In our view the market is overextending its bullishness that there will be a rate cut in February," he said.
Worried about underpriced risks posed by fiscal slippage and the RBI proving to be more hesitant reducing rates, Aditya Birla Sun Life has significantly cut holdings of long-tenure bonds and switched to tenures of one to two years.
Aberdeen has also cut its exposure to Indian debt paper during the past couple of weeks. The uncertainties have prompted some investors to sharply reduce their duration of debt holdings while many are switching to Indonesia, Malaysia, Philippines and Thailand.
India saw a sustained sell-off by foreigners who have sold $736 million of Indian debt so far in January on top $5.9 billion sold in 2018. In contrast, foreigners bought 7.09 trillion rupiah ($501.95 million) of debt in Indonesia this month after having pumped in 57 trillion rupiah ($4.05 billion) in 2018.
For all the near term uncertainty, foreign investors remain bullish on India in the long term given its stable macro-economic outlook and attractive returns.
"There is a bit of hesitancy ahead of elections about raising exposure to India, but we are constructive on India in the medium to longer term," said Kotecha.($1 = 14,125.0000 rupiah)