It is puzzling that foreign investors placed bids of $6.7 billion to buy local currency debt in the auction held by the Securities and Exchange Board of India (Sebi) on 21 June, since it comes after persistent selling of the same debt by the same investors in the preceding 20 trading days.
The return of investor interest is surprising for it comes in the wake of the 20 June meeting of the US Federal Reserve, when it reiterated its 23 May statement that quantitative easing (QE) would be phased out as the US economy improves. Last week was also characterized by exceptional volatility. The rupee rapidly fell by 3.5%, its one-month implied volatility rose 125 basis points (bps) and the one-year interest-rate swap zoomed 21 bps, the highest in a week since October 2011, according to Bloomberg data. One bps is one-hundredth of a percentage point.
That India’s economic fundamentals haven’t improved materially in this period deepens the enigma. If at all, persistent capital outflow, mainly from bonds, has further darkened India’s macro outlook. The 7% depreciation of the rupee since 23 May increases inflation and fiscal risks, while magnifying external funding pressures.
Foreign investors have been persistently heavy sellers of Indian debt since 23 May, when the US Fed chairman Ben Bernanke first hinted at a possible end to the QE programme. They dumped as much as $5.3 billion worth of bonds, effectively reversing the $6.4 billion of portfolio debt inflow since September.
The attempts by policymakers to inject confidence by listing positives such as a slight improvement in the current account deficit 4% of gross domestic product (GDP) last quarter, a sharp fall in June gold imports, low inflation, etc., had little effect. Bond yields, which had sunk below the policy rate floor before 22 May (thanks to receding inflation risks and expected monetary easing) have risen 15-20 bps as a result of the heavy foreign institutional investor (FII) selling. The policy easing by the Reserve Bank of India may now be punctuated by an extended pause. The yield advantage for FIIs has evaporated with rising US yields, a stronger dollar and higher hedging costs (6.5% by some estimates) of a riskier rupee.
Hence, the turn in the FII bond market presence, from net sellers to buyers and sellers, questions rationality. True, actual investment following the auction may take a while, or it might not come in at all. The bidders could also be a separate investor class—the enhanced $5 billion FII limits earlier this month, which was placed for auction along with the existing unutilized limits of $6.2 billion (the proportionate mix is not clear), was available only to foreign central banks, sovereign wealth funds, multilateral agencies, endowment funds, insurance funds and pension funds, and 37 bidders accounted for the bulk of the auction compared with 68 the previous month.
Nonetheless, if fundamental factors played a role in the $5.4 billion bond market sell-off, one wouldn’t expect foreign investors to commit nearly $6.7 billion in auctioned debt limits three weeks later. Have perceptions suddenly changed? What is it that foreign bond investors perceive as different? Was the earlier sell-off more about negative sentiments and less about local fundamentals? More importantly, how does one link the negative sentiments in the bond market to that of the foreign exchange market? Will the perceived reversal in sentiment in the bond market help the rupee to recover? Whatever be the case, market reactions in the near future may provide a clue. This is what deserves to be watched.
Renu Kohli is a New Delhi-based macroeconomist; she is currently Lead Economist, DEA-ICRIER G20 Research Programme and a former staff member of the International Monetary Fund and Reserve Bank of India.