FII flows in debt seen capped at $5-10 bn

Government securities, followed by corporate debt, will continue to remain most attractive for FIIs

Domestic debt markets are witnessing huge foreign inflows. So far in April, foreign institutional investors (FIIs) have pumped in close to $3 billion into Indian debt. Earlier, between October 2016 and February 2017, FIIs invested more than $10 billion in the debt market. However, this pace of inflows may not continue, believes Icra.

The FII flows into Indian market in 2017-18 could be between $5 billion and $10 billion as there could be several headwinds, says the rating agency.

"The recent surge of FIIs in Indian debt may not continue in the rest of this financial year, as factors such as a likely compression of spreads, geopolitical tensions, and sharp appreciation of the rupee would temper the attractiveness of purchasing Indian debt," Icra said on Wednesday.

Government securities (g-secs), followed by corporate debt, will continue to remain most attractive for FIIs, says Icra, adding that state development loans (SDLs) may not enthuse overseas investors.

"The bulk of FII inflows into Indian debt in 2017-18 would be in g-secs or corporate debt, as concerns regarding the recent rise in state debt would be worsened by non-debt servicing for Uday loans, pay revision, and potential loan waivers by some state governments, preventing a revival in FII interest in SDLs," said Icra. Uday is Ujwal Discom Assurance Yojana.

A likely hike in interest rate by Reserve Bank of India could also dent investor sentiment towards the debt market. "Given the rather hawkish tone of the recently released minutes of the April monetary policy committee meeting, there is a growing likelihood that the next rate action after a long pause would be a hike rather than a cut, which would entail a principal loss for investors at the time of sale or in mark-to-market terms. Therefore, funds brought in by FIIs into Indian debt markets during FY18 are likely to be primarily long term in nature, searching for higher yield rather than short-term capital gains," the rating agency said.

The rate forecast has seen yield on 10-year benchmark government security harden from 6.2 per cent in November 2016 to 6.96 per cent now.

Despite the huge recent inflows, there is enough headroom for further FII investment in the domestic market. According to data from National Securities Depository Limited, only 80 per cent of the FII quota for g-sec and corporate bonds has been used, while less than six per cent of the FII quota for SDL has been used.