Despite being just one step away from being downgraded by rating agencies and despite inflation risk rising, the government is considering raising foreign institutional investors’ (FIIs’) limits in government securities (G-secs) to avoid crowding out of private investment. Is this fortuitous liberalization or imprudent policy? The timing of a raise in cap indicates that it is being incorrectly sold as a quick fix to a funding problem, instead of a sequenced approach to capital account liberalization where positive and negative shocks can be well absorbed.
Illustration: Jayachandran / Mint
To be sure, with FII investments in G-secs currently capped at $5 billion and cumulative investments under 2% of the outstanding stock of G-secs, raising limits a bit more would be but a small step towards the eventual objective of full capital account liberalization.
But fiddling here and there with FII limits is really skirting the tough issue of managing capital inflows, rupee appreciation and the real economy. With domestic macroeconomic policies getting more difficult and interest rate carry trades—borrowing cheap dollars, yens or euros to buy high-yielding currencies elsewhere—back in vogue, flirting with short-term overseas investors is a proposition that could prove costlier than the flirtations with rupee appreciation in 2007. Attracting “hot money”, or short-term inflows, from abroad to address a domestic liquidity problem when uncertainty remains high is courting instability, and hardly a desirable goal of liberalization.
First, past trends show that FII investments in G-secs are strongly driven by interest rate and exchange rate fluctuations—correlation with short-term interest rate differentials when expectations of currency strengthening are high has been nearly 70%. Second, external determinants of these flows are cyclical for emerging markets—the combination of low inflation and high global liquidity between 2003 and 2008 propelled foreign investors to flood local currency bond markets. India was, and is, no exception to this trend. Third, much of the FII investment in India is at short maturities, betraying investors’ reluctance to expose themselves to interest rate and currency risks for a longer duration. Recent market reports say FIIs have mostly bought short-end paper— 91-day and 364-day treasury bills—reflecting their lack of long-term faith in Indian government assets.
In the event of a sudden exit—a high probability scenario—large and concentrated positions will adversely affect market liquidity and volatility. When a country has been assigned a minus BBB (denoting lowest investment grade), with a negative outlook by international credit rating agencies, any policymaker should wonder why, and for how long, investments in Indian assets are likely to continue.
FII investments in G-secs remain restricted in India because of persistent budgetary deficits, which demand a heavy reliance on market borrowings. These, in turn, are financed by public banks and financial institutions, which hold almost 70% of this debt. Along with statutory liquidity requirements and monetary management by the central bank, this arrangement assures the funding of budgetary deficits at a reasonable price and desired maturities.
This configuration is critical in mitigating the vulnerabilities of an internal imbalance; unless public revenues and expenditures improve structurally to eliminate this gap, a significant foreign investor presence would destabilize funding of budget deficits, since negative spending shocks make them flee abruptly; a sudden switch from domestic to foreign currency assets would also increase India’s external vulnerability.
These macroeconomic risks are getting overlooked in the zeal for bond market development, of which foreign investors are seen as an integral element. Assuming that fiscal consolidation would keep pace, the second S.S. Tarapore committee on fuller capital account convertibility in August 2006 recommended linking foreign investment limits in G-secs as a percentage of annual gross issuance, following which the Reserve Bank of India (RBI) announced a two-phase increase in October 2006: from the existing limit of $2 billion to $2.6 billion by 31 December 2006, and to $3.2 billion by 31 March 2007.
Reportedly, with foreign capital inflows swelling towards the end of 2006—approximately a monthly average of $4-5 billion between October and December, through external commercial borrowings and the foreign portfolio investment routes—RBI was less than keen for even the first phase of liberalization in December 2006, though it eventually came round to it.
The second increment, however, did not materialize as scheduled: The capital inflow boom was destabilizing monetary conditions with real appreciation pressures by early 2007; the foolishness of pro-cyclical liberalization in December 2006 had already become apparent; and RBI was strongly resisting further relaxations, much against the finance ministry’s wishes. The actual hike to $3.2 billion finally took place in January 2008, followed by another in June 2008 (to $5 billion).
The point this recapitulation serves to illustrate is that the timing and sequencing of liberalization must be synchronized with the macroeconomic situation—pro-cyclical or counter-cyclical, minimizing volatility or exacerbating shocks, etc., are policy choices to be exercised with care and caution, as hindsight shows.
Assuming that the Tarapore committee guidelines remain valid, FII limits could be poised to rise significantly as gross debt issuance itself mounts this year. But the passion for bond market development needs to be tempered with fresh lessons from the current crisis.
As the crises in the 1980s and 1990s were made worse by foreign currency-denominated debts, policymakers in emerging markets were convinced about developing local currency bond markets—to facilitate issuance of local currency debt and lengthen its duration, thus reducing currency mismatches and vulnerability to sudden stops. The short verdict on this approach has been that of a major policy success, which made several crisis-prone countries much stronger.
So did countries with more developed local bond markets fare better in the face of capital outflows in the current crisis?
The 2009 Annual Report of the Switzerland-based Bank for International Settlements (BIS) specifically examines this question. It finds that the crisis prompted foreign investors to pull out from local bond markets, switching to more liquid foreign currency assets.
This affected local bond markets in Hungary, Indonesia, Mexico and Turkey, among others, and exacerbated depreciation pressures. In Hungary, non-resident holdings declined sharply as foreign investors swapped local currency bonds for foreign currency; there were no bidders at bond auctions in mid-October and international banks were unwilling to swap euros for Hungarian forints, triggering a sharp depreciation.
Closer home, in Indonesia, portfolio investors led the capital outflow, reducing their holdings of central bank and government securities by some $6.5 billion, according to the International Monetary Fund (IMF) in its recently issued country report. Sovereign EMBI (emerging market bond index) spreads for Indonesia rose 1,200 basis points, much higher than comparable emerging market economies. Government bond yields zoomed to 20%, the rupiah depreciated by some 40%, market liquidity dried up and international reserves fell by $10 billion between July 2008 and October 2008.
The Indonesian government had to cancel all debt issuances till December and suspend mark-to-market valuations on banks’ government bond holdings; it eventually sought official external budget contingency financing for $5.5 billion. Plus, once a crisis has broken, the central bank is forced to raise interest rates to restore confidence and prevent an over-depreciation of the exchange rate—even in a recession.
This knowledge does take some of the shine off foreign investors in local debt markets, something Indian policymakers should take note of. They should perhaps be a little less romantically inclined to open up quickly to these inflows before they repair public finances.
True, less than 2% of India’s government bond stock is foreign-held, against 16% in Indonesia, and its macro indicators are far better than that of, say, pre-crisis Hungary; India also has a no-default sovereign record. But one indicator—its monumental public debt, now crossing 80% of gross domestic product (GDP)—is enough to tilt the scales. India doesn’t really need a crisis to prompt a sudden flight of foreign capital; a negative confidence shift—perhaps a downgrading or rising risk premium—could be the trigger, contributing to market volatility and liquidity pressures.
Debt tolerance of foreign investors is extremely low for emerging market countries, inversely proportional to the extent of financing by non-residents and directly related to low and volatile revenue-to-GDP ratios; bond investors, therefore, do not hesitate to punish offender governments, forcing governments to bring fiscal policy back in line or else precipitate capital flight. Is the Indian government ready for the policy discipline of such bond market vigilantes?
It would be rash to raise FII limits on the pretext of supplementing domestic resources when the short-term interest of the investors in quick arbitrage profits is explicit. As global liquidity and a resurgent risk appetite make carry trades attractive once again for foreign investors, it is extremely risky for India to widen their entry into the G-sec market when its fiscal and inflation outlooks are darkening and growth is below trend.
Next door, China is already experiencing monetary trouble with “hot money”. Can India be far behind?
Renu Kohli was until recently with the International Monetary Fund. Comments are welcome at firstname.lastname@example.org