FII G-sec limits: Achieves many objectives; reversal risk remains
The timing is particularly good since the move intends to tap the fearless buoyancy of global capital flows
The Reserve Bank of India (RBI) hiked foreign investment limits for on-auction government bonds by $5 billion last week. This amount must be ploughed in bonds of at least three-year residual maturity category. However, overall limits for foreigners remain unchanged as there is an offsetting reduction in the $10 billion limit available to long-term investors.
The action achieves multiple objectives and to the mutual satisfaction of both the government and the central bank. For one, it helps finance the fiscal deficit at lower costs. By directing foreign institutional investors (FIIs) towards the three-year residual maturity segment, the action creates fresh demand for government bonds, while lowering bond yields at the longer end of the curve. The timing is particularly good since the move intends to tap the fearless buoyancy of global capital flows, which are piling more into emerging market bonds.
According to the Institute of International Finance (IIF), portfolio capital flows to emerging economies accelerated in July, reaching a two-year high. In June, portfolio bond flows rose to the highest level since April 2013. India, Indonesia and South Africa were the major recipients in July. Unsurprisingly, foreign bond holdings of Indian local-currency bonds (sovereign plus corporate) stood at $38.8 billion as on 25 July, exceeding the May 2013 peak of $38.5 billion.
On its part, the central bank gained by shifting some more towards opening the debt market for short-term investors in a more “measured way". The central bank has long been uneasy at foreign investors’ tendency to buy short-term treasury Bills, from which they were barred a few months ago with the intention of reducing market volatility. To address the reluctance of FIIs in increasing exposure to the long-term Indian interest rates, the central bank is simultaneously working on building investor confidence by shifting to an inflation-targeting regime in January this year.
Reversal risk remains high as before, for there is no lock-in period for foreign bondholders, who can sell-off and depart whenever they choose. Since the risk appetite of portfolio investors reached a new high in July, according to the IIF, a sudden reversal could be equally sharp. At this point, capital flows to emerging markets are vulnerable to two possibilities suggested by IIF. One, a possible escalation of the Ukraine crisis and two, surprises in the timing, pace and magnitude of an eventual Fed policy tightening. But then, RBI is far better prepared for a sell-off this July, compared to last year’s taper mayhem. It has been accreting forex reserves, buying as much as $19 billion forwards in May. It will probably buy much of the future expected inflow, further raising its current reserve-holdings of $318 billion. From a fiscal perspective, of course, a sudden sell-off could hit hard. Borrowing costs could rise, especially if domestic appetite for government paper remains lukewarm. For the time being, markets have welcomed this move, while credit rating agencies are equally pleased.
Renu Kohli is a New Delhi-based macroeconomist.
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