RBI allows more FPI access to Indian bonds, but returns may not lure flows

Treasury officials believe the move may not work as rising interest rates abroad and high domestic inflation have eroded returns from Indian fixed-income assets

The Reserve Bank of India permitted foreign portfolio investors (FPIs) a larger share in Indian debt earlier this week, in a bid to attract more overseas investment flows at a time when the country’s Current Account Deficit is on the rise.

Treasury officials, however, are of the view that the steps may not cause a significant uptick in foreign investment as rising interest rates abroad and high domestic inflation have eroded returns from Indian fixed-income assets.

On Wednesday, the RBI expanded the basket of securities which fall under the ‘Fully Accessible Route’ for FPIs to include 7-year and 14-year sovereign bonds. Prior to this, FPIs were only allowed unrestricted investment in 5-year, 10-year and 30-year bonds.

The central bank removed a 30 per cent limit on overseas investments in government and corporate bonds with a residual maturity of less than one year till October 31, 2022. A window was also provided to permit FPIs to invest in commercial papers and non-convertible debentures with an original maturity of up to one year till October 31.

Through these steps, the central bank is essentially looking to bring in greater foreign investment in short-term securities, which hold a lower degree of risk on bond portfolios.

However, as the data on FPI investment in Indian debt shows, overseas entities have evinced little interest in domestic debt over the last few months. At present, FPIs have utilised a mere 28.6 per cent of the Rs 1.9 trillion general category investment limit in central government bonds, Clearing Corporation of India Ltd data showed.

So far in 2022, the net outstanding FPI investment in the general category has dropped by Rs 10,723 crore, the data showed.

An analysis of current returns from Indian short-term bonds shows little incentive for FPIs to enter the market in a meaningful way.

“The one-year point, which is where the RBI’s relaxation is, is where you generally would have seen interest but if you look at the one-year point now, if you look at T-bills… the numbers are not adding up,” PNB Gilts Managing Director and Chief Executive Officer Vikas Goel said.

They don’t want to do credit risk. Essentially, if you take a one-year T-bill which is around 6.15% - the cost of hedging on a fully hedged basis is roughly around 3.5%, so then you are left with around 2.65%. The one-year US Treasury is above 2.65%,” he said.
 

Moreover, in the current scenario of considerable volatility in the domestic exchange rate, overseas investors are unlikely to consider unhedged investment in Indian securities.

The rupee, which has weakened 6.2 per cent against the US dollar so far in 2022, touched a fresh low of 79.36/$1 on July 5.  A depreciating rupee eats into FPIs’ returns from Indian debt.

“Right now there is not much confidence on the rupee. At least among the foreigners, it seems to be an article of faith that the rupee could go to 81 or 82 per US dollar. So, they would rather prefer to wait it out,” Goel said.

The turbulence in the exchange rate has intensified over the last couple of weeks due to a surge in the dollar index as investors have rushed to the safety of the US currency amid global recession fears.

The dollar index was at a 20-year high of 107.21 on Friday, Bloomberg data showed. So far in 2022, the index, which measures the dollar against six major currencies has strengthened 10.8 per cent.

From a structural point of view, treasury officials said that the biggest deterrent for FPIs’ entry into Indian bonds was high domestic inflation.

Inflation eats into the fixed returns offered by debt instruments. Dealers said that while the Reserve Bank of India has hiked commenced on tightening monetary policy, interest rates would have to go up much further before returns on Indian debt turned attractive relative to inflation.

Consumer Price Based inflation was at 7.04 per cent in June, well above the RBI’s target band of 2-6 per cent. The RBI forecasts average inflation at 6.7 per cent for the current financial year. The benchmark policy repo rate is currently at 4.90 per cent. Yield on the 10-year benchmark government bond closed at 7.42 per cent on Friday.

“The broad view on rates has to change and I don’t see that happening anytime soon,” ICICI Securities Primary Dealership’s Head of Trading Naveen Singh said.

“The real yield is a problem. When FPIs have an allocation for a longer period, they see whether there is value in terms of when inflation would be heading down significantly. They want to gauge value in the bond,” he said.