Jury is out on the impact of RBI’s FPI measures

FPIs might have cut positions but many are waiting for the bond rout to end

As the short-term borrowing cost of companies spiked and foreign portfolio investors (FPIs) liquidated their bond holdings in India for greener pastures, the Reserve Bank of India (RBI) came out with various remedial measures.

In the first week of April, the central bank had increased the limit of foreign investment in Indian bonds to 6 per cent of the outstanding (in two phases till 2019-20), from 5 per cent now. By the end of April, it allowed foreign investors to invest in any maturity they wished to, from the earlier restriction of investing only in papers with a residual maturity of at least three years. In corporate bonds though, the minimum residual maturity is one year, down from three years. While it did raise the cap on aggregate FPI investment in any government securities to 30 per cent, from 20 per cent earlier, the central bank also imposed a new limit that investment below one year should not be more than 20 per cent of the book.

In April, FPIs liquidated about ~120 billion in debt, while RBI sold at least $5.5 billion to stem the rupee's slide. The rupee closed at 66.87 a dollar on Friday, while the 10-year bond yield closed at 7.73 per cent, more than one percentage point increase in about six months.

The end-April measures were largely a reversal of restrictions put in place by RBI in July 2014, but the concentration limit was a new introduction.

The measures, including the decision to purchase bonds from the secondary market, as well as heavy intervention to stem rupee loss, should address much of the pressure faced by foreign and domestic investors.

However, opinion is divided over whether the renewed play by FPIs in domestic debt would be harmful in the long run, if the policies are here to stay. FPIs do not have much stake in the domestic debt market. It is not even sufficient for the country to get into a global bond index, which often demands that a country have at least 10-20 per cent of its domestic debt market open for foreign investment.

But, the inclusion in a global bond index is often good for the country, as serious bond investors have mandates to only invest in bonds of an indexmember country. A point here is that Indian equity is already part of a global index, Morgan Stanley Capital International.

"The $70-billion of FPI in debt investment is off-benchmark bets on India. In the event of a domestic or a global riskoff, these investments are vulnerable to reversal. Index administrators do not like limits on foreign ownership and India has resisted unrestricted access to foreigners," said Ananth Narayan, associate professor, SP Jain Institute of Management and Research.

In the absence of a global index, and allowing foreigners access to shortterm bonds, it is an invitation for yield-chasing speculators and rate arbitrageurs. The central bank has always been wary about this for the way such 'hot money' can wreak havoc in the bond and currency markets when a risk-off environment grips the global economy.

To invite more serious players in the bond market, India created large separate positions for long-term investors, such as pension funds, multinational organisations and sovereign funds. The idea is that the money stays in India and the system gets insulated from shocks such as during the mid-2013's 'taper caper', when the US Federal Reserve said it would stop buying toxic bonds.

Such was the damage done to the rupee because of dollar shortage that time that the central bank had to do some liquidity and rate intervention, pushing up short-term yields by 200 basis points in less than a month, in July 2013. Meanwhile, the rupee hit a lifetime low of 68.87 a dollar that August.

In July 2014, RBI plainly said FPIs could not invest in short-term bonds any more. This made quick liquidation a challenge for investors and bond and rupee rates stabilized. Aided by measures such as allowing non-resident investors lucrative interest rates on dollar deposits.

Concerns

The immediate concern is that developed countries have started recovering and their bond yields are rising. Crude oil prices are rising and so is the dollar. The rupee has depreciated about 4.5 per cent since the start of the year, making it the worst performing currency in Asia year-to-date. A depreciating currency with a rising bond yield is not good for foreign investors. Not only do prices of bonds erode with every rise in yields but the real return could be wiped out by exchange rate loss.

India is not alone in this conundrum. Money seems to be flowing out from oil importing to exporting nations, which until recently faced severe uncertainties in the face of plummeting crude oil prices.

"Considering macro prudentialities, emerging markets (EMs) have limited ability to ensure continuous flows amid rising external adversities. Such a condition intensifies competition within EMs and opens the door for more volatile flows. The current situation might prove more favourable for oil-producing EMs with currencies pegged with the dollar," said Soumyajit Niyogi, associate director at India Ratings.

Serious foreign investors enter the country on a fully hedged basis, which adds to 4-5 percentage points in interest rate.

In the case of India, though, FPIs were happily invested even when local yields were less than 7 per cent. That is because a stable currency since late 2013 eliminated the need for hedging.

Most of the speculator class of FPIs are almost never hedged and freely enter or exit a country for quick arbitrage opportunities. They not only bet on bonds but also on the rupee and, in the process, destabilise both.

In the past, some of the FPI debt flowing into short-term bonds was merely locking onshore-offshore forex (FX) arbitrages, Narayan said.

When markets are stable, offshore dollar-rupee (D-R) forwards are lower than onshore, and FPIs can invest in short term paper, buy D-R in the offshore market, and lock in good spreads. If markets have a riskoff event, offshore FX forwards generally move up more sharply than onshore yields. FPIs can then unwind both their India short-term bond position and offshore FX trades at an even higher net profit. This explains a part of the large FPI debt outflow of June 2013, during the taper tantrum.

"There was a reason for the three-year minimum residual tenor restriction for FPI debt investment. The relative stability in FPI debt flow after 2013 is at least partly because the subsequent three-year residual tenor restriction reduced such opportunistic arbitrage flows. I am not sure if it was necessary to open this window now, and risk diluting the quality of debt flows once again," said Narayan.

What now?

For now, it seems the RBI might have done enough. Not everything is in RBI's hands and it is also not true that FPIs have left the country to never return. They might have cut positions as of now but many are waiting on the sidelines for the bond rout to end.

The decision to purchase bonds from the secondarymarket and heavy intervention to stem rupee loss should address the pressure faced by investors