Increase in FPI investment limit in Gilts - Do we need it?

Fiscal prudence versus adequate domestic appetite

There was need to attract foreign appetite to feed into huge Government borrowing to fund fiscal deficit at affordable cost. There was also need to get in foreign currency to fund huge Current Account Deficit and to arrest Rupee weakness. Hence, there was need to roll-out red carpet to Foreign Institutional Investors to invest in India Gilts, who made merry out of huge interest rate differential play between high yield India Gilts and Zero/Negative Interest policy regime in major markets. But, given the huge volatility in India Gilt yields and steady depreciation in the exchange rate, it is not a guaranteed return play! Most often, the FPI investment flows turns out to be a herd behaviour, either huge inflows or lumpy outflows. When the going is good, RBI step in to absorb excess $ supplies and incur sterilisation cost, building $ assets against Rupee liabilities with negative carry. It also creates importer's greed and exporter's fear syndrome on risk of extended Rupee appreciation, if RBI chose not to give cheap Rupees to foreign investors. When the going gets tough, Rupee exchange rate is at the mercy of foreign institutional investors, against limited bandwidth with RBI to protect Rupee weakness. It also creates importer's fear and exporter's greed against risk of sharp Rupee weakness. Most often, Indian entities get caught on the wrong foot, adding to NPA woes on the banking system. All taken, FII presence in Gilt market has done more harm than good, leading to exchange & interest rate volatility and sterilisation cost on the exchequer.

Now, dynamics have turned better - fiscal prudence is now established reducing the debt burden on the system; CAD is sharply down from over 4% of GDP to below 2% of GDP. The domestic appetite is huge to easily absorb Government's market borrowing schedule. The need is also to move away from hot money FII flows to stable FDI flows to establish exchange & interest rate stability. Going forward, dynamics could only become better with fiscal deficit target at/below 3.5% of GDP and possibility of turning zero deficit on Current Account. The need for FY16-FY19 is also to keep Rupee exchange rate competitive to exports and attractive to FDI flows. Given the conflict in monetary stance between RBI and the FED, and inflation trend (India CPI inflation under pressure at 5-6% and that of US steady at 0-2%), there is need to keep long term yields high to prevent run on the Rupee exchange rate. Given this scenario, is there a need to increase FII investment limit in Gilts? Why not look at shifting the limit from Gilts to other sectors where liquidity is scarce?

Will FPI welcome this move?

Most FPIs have lost out on India Gilt portfolio - 10Y bond yield is volatile, up from 7% to 9% to 7.5% since August 2013 against sharp depreciation in Rupee since May 2014. The short/long term outlook on US-India interest rate scenario against bullish trend of the US Dollar do not provide a good risk-reward play to FPIs to welcome (and absorb) the increased limit. The dependence on FPI inflows need to be cut, with the need to reduce the impact of sudden mood-swings of hot money flows hurting domestic stakeholders leading to excessive volatility beyond absorption capacity. With most anticipate spike in US 10Y yield into 2.50-2.85% (India 10Y into/beyond 7.85-8.0%) and DXY rally from 93 to over 100 (USD/INR from 63 to 68) by end of 2015 through 2016, the action to hike FPI limit may be a non-starter!

Timely benefit to domestic stakeholders

10Y bond yield was at risk sustainability at 7.90-8.0%. The two-step measures, first RBI support at 7.90% and Finance Ministry's agenda on limit enhancement shift focus from 7.90-7.93% to 7.70-7.73%. This is huge benefit for Banks and Corporate entities (with open foreign currency liability exposures) ahead of Q1/FY16 results. The mark-to-market hit from post 2nd June policy spike in 10Y yield from 7.62-7.65% to over 7.90% is hard to absorb for Banks against earning pressure and higher credit loss provision. For whatever worth to FIIs, it is indeed welcome relief for Banks and Foreign currency borrowers from drop in 10Y yield from over 7.90% into 7.70% and Rupee recovery from 64.30 to 63.50.

USD/INR exchange rate into 63.00-63.50 is welcome relief for importers and foreign currency borrowers to stay risk-off (or risk-neutral) post the fear of Rupee depreciation beyond 64.20-64.35 into 64.85-65.00/66.50. Bank's position is bit mixed; if chose to trim investment (or cut duration) at 10Y yield below 7.72%, resultant spike will cause hit on existing stock. If they don't, will FPIs step in to drive the 10Y yield into 7.65-7.70/7.72% for temporary relief in Q1/FY16 results? What next for Q2/FY16 if 10Y back at/over 7.90% on start of rate hike cycle by FED in September? It is kind of between the devil and deep sea for the Banks! It will be interesting to watch on the way forward. For traders, who rode the post-policy volatility from 7.62-7.65% to 7.90-7.93% to 7.70-7.73% can stay aside till stability is restored for better clarity ahead!

Going forward, Finance Ministry's pressure for rate cut will be on the Banks, and not RBI atleast till end of 2015. Given this against higher probability of 50 bps hike from the FED during the same period, bond yields at current (against cheap dollar) will be attractive for FPIs to take profit or cut loss (against limited upside and significant downside risk), and not adding to current portfolio!

Moses Harding