Mumbai: The Reserve Bank of India (RBI) and the finance ministry have kicked off discussions to raise the limit on investments by foreign institutional investors (FIIs) in the local debt markets, according to senior officials in the government and the central bank who are familiar with the matter.
The discussions come at a time when India needs strong capital inflows from overseas investors to finance a current account deficit that is at its highest level since 1991 even as the global economic outlook is getting increasingly cloudy.
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“The global near-term outlook for trade and capital flows is uncertain,” the central bank said in its annual report released earlier this week, though its concerns seemed to be dominated by the fear of a sudden surge in global capital inflows later this year.
FIIs are currently allowed to invest up to $20 billion (Rs93,600) every year in bonds—$15 billion in government bonds and $5 billion in corporate bonds. They have poured in $16 billion this fiscal. The limit on investment in government bonds has already been reached.
RBI had previously raised the FII investment limit in local debt in January 2009, when foreign money had fled the Indian stock market and domestic liquidity had dried up as a result of the global panic in the aftermath of the collapse of investment bank Lehman Brothers.
While India has traditionally been wary of foreign capital inflows into its debt markets, some economists believe it is time to completely do away with such restrictions.
“Why do we need to have such a limit at all? These quantitative restrictions (QR) are really damaging. Through QRs, foreign investors lack the incentive to build a deep engagement with India in terms of building a research staff, a sales force, a back office, etc. Indian bonds will not graduate into global debt portfolios until the QR is removed,” said Ajay Shah, professor at think tank National Institute of Public Finance and Policy.
“My concerns are only when the debt is denominated in dollars, which is termed ‘original sin’. As long as the bonds are denominated in rupees, there should not be any concern on how much sovereign debt foreigners are holding: the foreigner is the one bearing the currency risk,” he added.
Bond investors said that increased foreign inflows in government and corporate bonds at this juncture could take some pressure of the local money market, where strong demand for funds from the government to fund its fiscal deficit and companies to finance their activities has pushed up interest rates.
However, there are also worries that foreign capital would tend to flow into short-term debt issued by the government and companies. Such short-term debt flows can be more volatile and unsettling.
According to debt market participants, FIIs typically go for short-term investment, preferring to invest in short-term paper. “Generally they don’t want to take the risk of interest rate volatility at the longer end, typical in emerging markets economy, especially when inflationary pressures are strong,” said Manish Sarraf, head of treasury at Dhanlaxmi Bank Ltd.
“They always prefer instruments in which positions can be unwound quickly rather than accounting for mark-to market losses,” Sarraf added.
Mark-to-market is an accounting practice of assigning a value to a position held in a financial instrument, based on current market price and not at the price at which it was bought.
This short-term investment behaviour worries RBI and the government, said senior officials. India has traditionally been wary of short-term capital inflows of the sort that destabilized Asian economies in 1997.
Central banks in rich nations have maintained interest rates close to zero in a bid to fend off deflation and a double-dip recession. These policies have allowed yield-hungry investors to borrow cheap in currencies such as the dollar and the yen, and make arbitrage profits by investing the money in higher-yielding bonds in countries such as India.