Investors in India are shunning gold while adding to holdings of government bonds, betting that policy makers will cut borrowing costs as inflation slows to the least in two years.

Assets managed by funds that buy bullion shrank 4.3 percent to 91.5 billion rupees ($1.8 billion) in December, while those that trade in rupee-denominated sovereign debt increased 17 percent to 31.2 billion rupees, according to the Mumbai-based Association of Mutual Funds in India. Gold imports by the world’s biggest buyer may slump 48 percent in the three months ending March from a year earlier, the Bombay Bullion Association said this month.

Government notes are rallying before data next week that economists predict will show wholesale prices rose 7.4 percent in December, compared with 9.11 percent in November, a sign that seven interest-rate increases last year are taming price pressures. The nation’s 10-year bonds yield 8.23 percent, 83 basis points more than the inflation forecast. China has so- called real interest rates of minus 70 basis points, while South Korea’s are minus 41.

“Indian investors’ sacred affinity toward gold will be tested by factors like real interest rates and investment opportunities in other assets,” Ritesh Jain, the Mumbai-based head of investment at Canara Robeco Asset Management Ltd. that oversees $1.3 billion, said in an interview yesterday. “Demand for gold in India may fall 25 percent to 30 percent in 2012.”

Borrowing Costs

The metal was being perceived as a hedge against inflation through last year, Jain said, as increases in wholesale prices held above 9 percent for 12 consecutive months through November. This was especially so in rural India, where banking facilities “continue to be dismal,” he said.

Funds that buy gold managed 2 percent of total assets invested by India’s investors in mutual funds at the end of December, compared with 20 percent overseen by those that trade in bonds due in less than 12 months. Debt securities with maturities longer than a year accounted for 49 percent, while equities made up 23 percent.

The nation’s interest-rate swap market suggests that borrowing costs will decline. The cost to lock in interest rates for 12 months dropped one basis point, or 0.01 percentage point, to 7.9 percent yesterday. That’s 60 basis points below the Reserve Bank of India’s 8.5 percent repurchase rate. Goldman Sachs Group Inc. predicts policy makers will cut the repo rate by 1.5 percentage points this year, while Deutsche Bank AG estimates a one percentage point reduction.

Rupee Advances

Global funds are adding to holdings of the nation’s debt securities before the central bank reviews borrowing costs on Jan. 24. International investors bought more rupee-denominated notes than they sold for a seventh consecutive trading day on Jan. 10, boosting their ownership this month by $1.8 billion to $27.8 billion, according to exchange data.

The purchases are spurring a rally in government bonds and the rupee. Yields on the nation’sbenchmark 8.79 percent notes due in November 2021 have slumped 32 basis points this year after increasing 65 basis points in 2011. The yield rose two basis points to 8.25 percent yesterday, according to the central bank’s trading system.

The rupee, Asia’s worst-performing currency last year following a 16 percent slide, gained 0.6 percent yesterday to 51.585 per dollar, according to data compiled by Bloomberg. The currency has strengthened 2.9 percent in 2012, the best performance among the region’s 10 most-traded currencies.

Gold Slumps

Gold for immediate delivery, which gained 10 percent in 2011, has slid 14 percent after touching a record $1,921.15 an ounce on Sept. 6 and traded at $1,656.88 in Mumbai yesterday.

Imports of the metal may decline to 150 metric tons in the three months through March, from 286 tons a year earlier, as the rupee’s 2011 decline boosts prices, Prithviraj Kothari, president of the Bombay Bullion Association, said in an interview.

“If gold were to correct, especially in the near term, and the rupee were to remain sideways, it wouldn’t augur very well for the investor,” Lakshmi Iyer, head of fixed income and products in Mumbai at Kotak Mahindra Asset Management Co. that oversees $5.7 billion, said in an interview on Jan. 11. “Sentiment is biased toward investing in fixed income over any other asset class for now.”

The cost of protecting the debt of State Bank of India, which some investors consider a proxy for the nation, is climbing as Europe’s debt crisis dims the allure of emerging- market assets.

Cultural Factors

Credit-default swaps on the lender cost 392 basis points yesterday after touching a two-year high of 405 on Jan. 9, according to CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in privately negotiated markets. The swaps pay the buyer face value for the underlying securities should a company fail to adhere to its debt agreements.

With Europe’s sovereign-debt crisis spreading “like a plague,” gold will continue to attract investment in 2012 because of its appeal as a haven, according to Reliance Capital Asset Management Ltd.

Demand will also be supported by cultural factors as gold is an important part of family occasions in India such as weddings, Sundeep Sikka, the Mumbai-based chief executive officer at Reliance Capital, said in an interview on Jan. 6. Hindus, who account for about 80 percent of the nation’s population, also consider buying gold auspicious during religious festivals.

‘Extremely Bullish’

“Demand for physical gold has always been strong in India,” Sikka said. “The current global macroeconomic environment is very conducive for higher gold prices. The fundamental outlook for gold remains extremely bullish.”

Slowing growth in Asia’s third-biggest economy will damp demand for bullion, according to Canara Robeco’s Jain.

Sales of passenger cars in the nation fell almost 7 percent from November to 159,325 units last month, according to data from the Society of Indian Automobile Manufacturers. Gross domestic product will rise about 7 percent in the year ending March, Prime Minister Manmohan Singh said on Jan. 8, less than a prediction of 7.5 percent he made in December.

India’s bonds have returned 1.2 percent this month, the best performance among 10 Asian local-currency debt markets monitored by HSBC Holdings Plc. The difference in yields between rupee-denominated notes due in a decade and similar-maturity U.S. Treasuries has narrowed 31 basis points in January to 631.

“With easing of inflation, people aren’t thinking of buying gold,” Chirag Mehta, Mumbai-basedfund manager at Quantum Asset Management Company, a unit of Quantum Advisors Pvt. that manages about $1.1 billion, said in an interview yesterday. “Investors are thinking that bond yields have peaked and it’s a good time to invest in government bonds.”

To contact the reporters on this story: Madelene Pearson in Melbourne atmpearson1@bloomberg.net; Swansy Afonso in Mumbai at safonso2@bloomberg.net

To contact the editors responsible for this story: James Poole at jpoole4@bloomberg.net; Sandy Hendry at shendry@bloomberg.net

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