The ongoing surge in foreign inflows into the debt market is unlikely to continue during the rest of fiscal 2018 due to geopolitical tension and the sharp rise in the rupee, warned a report on Wednesday.
"The recent surge of foreign portfolio investors' (FPIs) investments into the domestic debt is unlikely to sustain through the rest of fiscal 2018, as factors such as a likely compression of the spreads, geopolitical tension and the sharp rise in the rupee will temper the attractiveness of debt," said the report by rating agency Icra.
After recording outflows of $7.1 billion during October 2016-January 2017, FIIs have invested $7.4 billion in the country's debt market since February 2017. Inflows stood at $3.9 billion in March, the highest monthly tally since December 2011.
This was aided by factors such as a widening of the spreads between the 10-year USS and domestic G-secs yields, the receding impact of the note ban on economic activity and investor sentiment, as well as policy reforms including the passage of all the GST laws, the report said.
Aggregate FPI utilisation of debt cap rose from 64.5 per cent in January to 72.1 per cent in March, and further to 74.7 per cent in April, despite the planned rise in the limits for government securities and state development loans. But this trend of large monthly FPI inflows into the debt markets is unlikely to sustain in coming months, the report warned.
"Based on the expected rate actions by the US Fed and RBI, we expect the spread between the US and Indian yields to decline, reducing the attractiveness of holding Indian debt for FPIs."
This could lead to lower monthly inflows relative to the trend seen in the recent months, as well as sporadic outflows of FII investments in domestic debt debt, it said.
Given the likely outlook for inflation and tightening of labour market conditions, the US Fed is likely to continue with monetary tightening, with at least two more rate hikes expected in 2017, Icra said.
Moreover, there is a growing likelihood that the Fed would start to taper the reinvestment of maturing proceeds of its bond holdings, to reduce the size of its balance sheet, by the year-end. This would shrink the demand for US debt, further boosting yields, it said.
The agency said the trajectory for CPI inflation in FY18 will be influenced by the monsoon dynamics, changes in the housing inflation related to the revision in HRA following the seventh pay panel award, the impact of GST on prices, and to a smaller extent, commodity price movements and the rupee- dollar rates.
Compared to its goal of bringing CPI inflation in a durable manner to 4 per cent, trajectory indicated by the RBI builds in a hardening of inflation from 4.5 per cent in first half of to nearly 5 per cent in the second half of the current financial year.
The impacts of monsoons and GST won't be clear for at least a few more months, which suggests a high likelihood of a prolonged pause for the rates, the report said.
The report said given the rather hawkish tone of the recently released minutes of the April MPC meeting, there is a growing likelihood that the next rate action will come after a long pause and would be a hike rather than a cut. A rate hike would lead to a firming of domestic yields, and a decline in bond prices, which would entail a loss for investors.
"Therefore, we expect the funds brought in by FPIs into the domestic debt markets in the current financial year to be primarily long-term, searching for higher yield rather than short-term capital gains," it added.