Falling rupee hurts debt market

Foreign investors keeping off; inflows into bonds also likely to improve if RBI resumes rate cuts

The falling rupee might continue to keep foreign investors away from Indian debt in the near future. In the past month, these investors sold debt of Rs 18,345 crore ($3.19 billion) and the trend is likely to continue until the rupee shows stability. It has plunged 7.1 per cent in the past month and is near its all-time (intra-day) low of Rs 58.99.

As compared to debt, equities have witnessed lower selling pressure. Foreign investors have sold equity of only Rs 1,374 crore in June. Global uncertainties have seen them taking a breather from buying Indian equities lately and lack of buying from domestic institutions has resulted in lacklustre markets. Foriegn institutional investors (FIIs) are said to be taking a wait and watch approach, looking for cues from the Fed's meeting tomorrow.      

But it's the redemptions in the debt segment that has the government worried. Bond experts say the biggest factor which has driven away foreign investors has been the volatile rupee. The cost of holding domestic bonds has increased, as foreign investors pay more towards higher hedging due to the rising foreign exchange risk. Foreign investors also see payouts from their Indian domestic holdings shrink when the rupee falls.

Indian debt yields are higher than in other emerging markets but the high returns might not be attractive enough against a falling rupee. Says Kaustubh Kulkarni, head of local currency debt, Standard Chartered India: “The current market dislocation is temporary and is happening due to volatility in the forex market. The rupee movement can significantly dent a bond investor's profit.”

Emerging market bonds have seen sharp redemptions of about $4.5 billion in the past month as investors worry the liquidity provided by the US Fed through its quantitative easing could taper off. Treasury yields in the US have increased, sparking a further exodus from emerging markets.  The difference in yields between the US 10-year Treasury and the Indian 10-year G-sec has reduced from 5.46 per cent to 5.09 per cent in the past month.

This has led to foreign investors rebalancing their debt portfolios towards developed markets. They were also sitting on large bond gains due to the cut in interest rates in domestic markets. Says Kulkarni: “Foreign investors had made a decent amount of profit on the corporate bond front and this is why they rebalanced. It's a relative value play that bond investors are looking at, after seeing forward yields and local bond yields.”

India's debt market share is less than five per cent of emerging markets’ debt; the impact of selling Indian debt in the local market has hardly affected yields.

As prices of bonds fall on heavy selling, yields rise but since the past month, yields have increased only marginally to 7.27 per cent (from 7.11 per cent in May). Says Neelkanth Mishra, India equity strategist, Credit Suisse: “India does not have a large share of emerging market debt allocations and is not benchmarked in emerging market indices. Therefore, the impact in India has been less.”

Experts reckon that many of these same investors who have been selling would re-examine India as among the major economies if it offers higher yields than other emerging-market countries.

The Reserve Bank of India (RBI) is also largely expected to cut rates going forward, though it paused on this in the latest credit policy. RBI was among the few central banks which had continued raising rates when other emerging market countries, such as Brazil, were cutting these.

In its latest credit policy statement, RBI said: “It is only a durable receding of inflation that will open up the space for monetary policy to continue to address risks to growth.” Analysts expect inflation to ease due to lower commodity prices and, in the second half, expect RBI to cut rates by a further 50 basis points.   

The expected rate cut could attract foreign buyers, as they gain from rising bond prices. But for that to happen, the rupee has to stabilise. Says Kulkarni: “If the rupee stabilises, I don't see why foreigners shouldn't be back in Indian bonds.”