Loosen the bond

The Reserve Bank of India’s medium-term framework to enhance participation of foreign investors in government securities was accompanied by more than one caveat — and quite rightly so. The central bank’s Governor said the implementation of the rules will be contingent on the reaction of financial markets to the Federal Reserve’s monetary tightening and improvement of liquidity in the domestic market. It cannot be denied that there is a strong case for increasing the limit of foreign portfolio investment (FPI) in government bonds. The great interest among foreign investors for Indian sovereign bonds, thanks to attractive real yields, is reflected in the fact that the current limit of $30 billion is entirely subscribed. The suggestion that the limit is determined by percentage of outstanding government securities rather than a number makes eminent sense. Foreign investors currently hold just 3.6 per cent of the government bonds issued. This is far below that in countries such as Brazil, Malaysia and Indonesia, where foreign holding of sovereign bonds exceeds 20 per cent. Specifying the limit in rupee terms rather than dollars is also a good idea, as currency fluctuation tends to shrink or expand the limit considerably.

But given the uncertainty facing the global financial market in September as the Federal Reserve begins raising interest rates, there is a case for caution in inviting more foreign flows into debt. Foreign investors in bonds are in it more for the short-term in comparison with equity investors; they are also more sensitive to yields and currency movement. Of the total limit for FPIs in bonds, only $5 billion is allotted to long-term investors such as sovereign wealth funds and multilateral agencies; the rest are owned by short- and medium-term investors. As yields in the US start moving higher, there could be another exodus of FPI money from Indian debt securities, akin to that witnessed in 2013. Between May and December 2013, foreign investors had pulled out more than a third of their cumulative investments in to India, due to the weakness in the rupee and soaring yields in the US. The central bank is aware of these risks and has, therefore, put in various measures to restrict FPI investments in short-term debt.

It is difficult to balance extra flows from foreign investors in bonds to bolster the currency and forex reserves and insure oneself against the volatility that these flows bring. One reason why FPI money causes so much volatility is due to the low liquidity in G-secs. This is because commercial banks hold more than 40 per cent of these securities as part of their statutory requirement and hence do not trade in them. The rest are held by large financial institutions and the RBI. The central bank should expedite the process of making retail investors participate in government bonds, a process put in motion last year. If retail investors can purchase these securities in a dematerialised form through stock exchanges, it will help counter the volatility caused by foreign flows.