Keeping faith? Not when it comes to India

Clouds gather over the Mumbai skyline June 21, 2010.

MUMBAI (Reuters) - The enthusiasm that propelled Indian markets at the start of 2012 is fizzling, as investors see big challenges ahead but have little confidence that policymakers will manage them well.

Markets are signalling deep uncertainty about India's ability to steer an economy not yet fully on the mend following recent policy reversals, including uncertainty about taxation of foreign investors.

The lack of confidence is compounded by fears about a cautious central bank, one that will n either deliver enough liquidity to ease an acute cash shortage among banks, nor enough cuts in the interest rates to boost economic growth.

Here are six market signals that show the deepening worries from investors.

OIL PRICES SURGE JUST AT THE WRONG TIME

The RBI had been expected to cut the repo rate aggressively in 2012, but that is no longer the case.

A Reuters poll shows a majority of analysts expect the central bank to ease the rate by 25 basis points on April 17, but expect only an additional 50 bps in cuts through the remainder of fiscal 2013.

The recent surge in oil is one key factor bound to keep India's central bankers concerned about inflation, given India is the world's fourth biggest consumer and imports almost 70 percent of its crude oil.

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BOND YIELDS UNLIKELY TO FALL TOO MUCH

Another factor may be even more important: the government's fiscal 2013 federal budget, which contained a higher-than-expected 5.7 trillion rupees in borrowing and a continuation of India's recent loose fiscal policy.

The bulk of that borrowing will happen over the first half of fiscal 2012/13, meaning a steady supply of bond sales that could prevent yields from falling too much.

Investors are also sceptical the government can meet its fiscal deficit target of 5.1 percent of GDP, and that is also reflected in the 10-year benchmark yield that recently hit a three-month peak.

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WHY REPO RATE CUTS MAY NOT BE ENOUGH

Another reason bond investors worry has to do with liquidity, seen by some analysts as an even more urgent threat to India than high interest rates.

Conditions in overnight indexed swap markets have eased somewhat, with the spread between the 1-year and the 5-year swap tightening after rising to a negative spread of as much as 107 basis points in September.

However, the spread is still deeply inverted, and the front-end of the curve will not gain much unless investors get more certainty about liquidity conditions and the extent of interest rate cuts in the fiscal year ahead.

The worry is that investors may not see much relief on either. The overnight call rate, though much lower than a recent peak of around 15 percent, is still above the repo rate, in a reflection of how tight interbank liquidity remains.

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BANKS NEED MORE URGENT LIQUIDITY MEASURES

Indian lenders' need for cash remains acute, as reflected by the high repo borrowings from the central bank.

The RBI has responded by lowering the cash reserve ratio, or the amount banks must maintain with the central bank, to 4.75 percent from 6 percent this year, and bought limited quantities of bonds via open market operations (OMOs).

That has not been enough. The loan-to-deposit ratio remains at record h igh l evels, as banks attract less in deposits than they lend out, a squeeze that keeps market interest rates high.

April usually brings with it an injection of government spending, but traders believe the RBI will have no option but to step in with more liquidity.

link.reuters.com/vyt57s

LETTING THE RUPEE GO

Traders are coming around to the idea that the RBI may not be able to defend the rupee as the current account deficit continues to widen, meaning the RBI will have to factor in the ensuing potential for higher inflation into its policy actions.

Capital inflows, which the government relied on to narrow the deficit, are expected to remain volatile, especially at a time of deep concern over the government's stance regarding foreign taxation and other policy reversals.

India's forex reserves have also fallen, to just below $300 billion, which could make the RBI more gun-shy when it comes to intervention, after selling a net $20.14 billion in spot markets from September to February.

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STOCKS STAY DEFENSIVE

The caution among investors is also reflected in stock markets.

A rally earlier this year in India's main BSE index is running out of steam, as foreign investors' net purchases slow.

That means investors have switched to a defensive stance, with both the health care sub-index and consumer goods, traditionally in demand during bad times, hitting record highs in April.

link.reuters.com/geb67s

(Reporting By Rafael Nam, Aditya Phatak, Archana Narayanan, and Abhishek Vishnoi; Graphics by Christine Chan)