The year 2012 was about walking the tightrope in managing inflation and growth with more focus on inflation, as the headline WPI number hovered in the 7.5 per cent range. It was also about aggressive easing on the liquidity front by the Reserve Bank of India, which reduced CRR by 175 bps during the year till date. RBI also reduced SLR requirements for banks by 100 bps in the same period. Hence CRR plus SLR cumulative liquidity easing has been to the extent of 2.75 per cent. Apart from this, RBI also reduced the operative rate, which is the repo rate, by 50 bps. All of these has led to some softening of rates, specifically on the credit side, where banks have been able to reduce lending rates

And finally, it was about the downgrade fear, which was mitigated in time by the government steps on reducing fiscal deficit by adjusting oil prices, specifically diesel prices, by more than 10 per cent in one go.

Heading into 2013, while inflation will be of significance, fiscal consolidation and reviving the growth momentum will receive maximum important. As we usher in the New Year, the prime trigger will come from the Union budget. Budget 2013 will be of extreme importance as the market will be watching the fiscal deficit and expected government borrowing targets for the new financial year. Risk remains, such as absence of a fiscal consolidation roadmap or several populist measures in the budget ahead of the 2014 election. On the other hand, if the budget and fiscal deficit target are within acceptable limits, it will be a positive trigger for the debt market

The biggest expectation from the debt market in 2013 would be reduction in rates. The year 2013 is very likely to meet market expectations on this front. If RBI gains comfort on the fiscal side, our highest probability bet is would be 50 bps rate cuts over the next six months.

On the positive side, while December inflation could be around 8 per cent, after that through the same should moderate to sub-7% level in calendar 2013. If RBI decides to oblige the market, there is a case for 10-year yields to drop by 20.25 bps from current levels to 8.15- 8.2 per cent range over the next few months.

The most pertinent and key tipping point for 2013 will be fiscal consolidation, the impact of which will be relevant to allow RBI some head room to reduce rates and mitigate any risk of a rating downgrade. The government will look forward to bringing down fiscal deficit within 5 per cent of GDP, by reducing the subsidy burden and divesting stakes in public sector undertakings.

While divestment is important to the agenda of fiscal consolidation, it will not be the core contributor given the absence of investor appetite in the market. The biggest contributor will, therefore, be subsidy reduction. If the government is able to reduce its subsidy burden, through measures such as fuel price hike and projects likes direct transfer of subsidies, they will help moderate fiscal deficit.

In the prevailing environment and given the downward bias in interest rates, debt funds should be able to provide stable returns, provided investors are in the right maturity basket, which are the short-term and medium-term ones. We, therefore, continue to recommend short-term plans, income funds and dynamic bond funds, which we believe will remain attractive in the New Year in terms of risk-adjusted returns. For more aggressive investors, gilt funds can offer a good investment opportunity in 2013. zz