By Anoop Agrawal July 23 (Bloomberg) -- India’s two-year bonds will rally as banks, the biggest buyers of government debt, shun longer-dated notes on concern officials will have trouble cutting the nation’s budget deficit, Royal Bank of Scotland Group Plc said. The Reserve Bank of India will tailor its monetary policy to aid the government’s record borrowing, while surplus cash at lenders flush with deposits will fuel demand for the securities, Britain’s biggest state-owned bank said in a research report yesterday. The government’s pledge to reduce its budget gap to 4 percent of gross domestic product in two years from 6.8 percent is “challenging” and will continue to “unsettle financial markets,” the report said. “Banks are worried about the long-term fiscal consolidation strategy, which is why they are not buying longer- term bonds even as liquidity is ample,” Sanjay Mathur, RBS’s Singapore-based economist, said in an interview. Investors should buy the 9.39 percent note due in 2011 at yields above 5.25 percent, RBS’s interest-rate strategist Nhan Ngoc Le wrote in the report. Nhan forecast the rate will slide 1 percentage point over six months, compared with a projected 30 basis point, or 0.3 percentage point, drop for 10-year debt. Investors should sell two-year notes if yields climb to 5.5 percent, he said. The benchmark two-year bond last traded on July 20 at 108.10 rupees per 100-rupee face amount, to yield 4.97 percent. Nhan recommended avoiding bonds maturing in five years and more “given weak demand, uncertainty about long-term issuance and thin cushion against a potential rise in rates.” Budget Shortfall India’s Finance Minister Pranab Mukherjee, in his Budget speech on July 6, estimated the budget deficit will reach a 16- year high in the fiscal year ending March 31. His ministry set an unprecedented borrowing target of 4.5 trillion rupees ($93 billion) as Prime Minister Manmohan Singh increases spending to revive an economy expanding at the slowest pace in six years. The central bank has cut its overnight lending rate, or repurchase rate, six times since mid-October to a record-low 4.75 percent to stimulate demand in Asia’s third-biggest economy. India’s rupee will strengthen 10.3 percent to 44 per dollar in the third quarter as the nation’s improving balance of payments becomes “the most dominant driver,” Mathur and Nhan wrote. The broad measure of capital inflows and outflows turned to a surplus of $300 million in the quarter ended March 31, from a record $17.9 billion deficit in the previous three months. The rupee, which has appreciated 3.8 percent in the past three months, closed at 48.52 per dollar yesterday in Mumbai, according to data compiled by Bloomberg. To contact the reporter on this story: Anoop Agrawal in Mumbai at aagrawal8@bloomberg.net.

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