Mumbai: The spread between the 10-year US treasury and Indian sovereign paper is at a historic high of 5.667%, the highest in emerging markets. This indicates foreign funds will continue to flow here.

The Indian 10-year bond yield ended at 8.146% on Wednesday, higher than the 2.479% on the US 10-year paper. On Thursday, the yield on the 10-year government bond held to its near two-year high level of 8.13%. The 10-year US treasury yield was 2.506% at the time of going to press.

“The rate differential is more attractive now and should bring in even more capital inflows if interest rates rise," said Rajeev Malik, senior economist of CLSA Singapore Pvt. Ltd.

Economists and bond traders said the prospect of a further surge in inflows will directly impact the decision of the Reserve Bank of India (RBI) on 2 November when it reviews monetary policy for the second half of the fiscal to March 2011.

Graphic: Ahmed Raza Khan/Mint

If RBI hikes rates to fight inflation, it will increase the rate differential and that will attract more foreign capital. Many emerging market economies are fearing this, and some of them are contemplating measures to check foreign funds flow.

“The implications of this historic high (yield differential) is huge amount of flows into the country. But India is insulated because we limit the amount foreign funds can invest in debt, unlike Brazil and Thailand, where there are no (quantitative) controls," said Abheek Barua, chief economist of HDFC Bank Ltd. “But what it means is that cheap dollars will come into the equity market, pressuring the rupee for a long time."

Cheap dollars could also impact trade finance and external commercial borrowings as Indian companies could increase their dollar fundings, he said.

Equity markets have been a favourite with foreign investors this year with investments of a record $23.78 billion (Rs1.05 trillion). In September alone, they invested $6.37 billion, highest in any single month. The flow has also increased because of a series of high-value initial public offerings of state-owned firms.

Coal India Ltd, the world’s largest producer of the fuel, is selling as much as Rs1,515 crore worth of shares in the nation’s biggest initial share sale. India plans to step up share sales in the next six months and offer stakes in seven companies including Indian Oil Corp. Ltd.

RBI deputy governor Subir Gokarn had said in early October that the central bank would find ways to intervene if the capital flow is huge. Governor D. Subbarao said in Washington that the bank is ready to intervene to restrict capital inflow if it believed “the inflows are lumpy and volatile" or they “disrupt the macroeconomic situation".

“Such verbal intervention is usually a prelude to action," Nomura economists Sonal Varma and Ketaki Sharma wrote in a research report titled Global Weekly Economic Monitor.

Finance minister Pranab Mukherjee has said there is no plan to curb capital flow.

Economists and bond dealers say capital flow in India may not be bad. India’s current account deficit is at elevated level of 3.7% of gross domestic product. The deficit is automatically financed by the capital flows, which leads to economists suggesting that any kind of capital control is not advisable. Instead, RBI could let rupee to rise further, as further as 43.1 a dollar by end-2010, said Nomura. After that, RBI can go for “unsterilized intervention", a term used when the central bank buys dollars from the market and releases an equivalent amount of rupees in the system.

Such unsterilized intervention could be necessary because of tight liquidity. Banks have been heavily borrowing from RBI in past few weeks. On Thursday, they borrowed around Rs73,000 crore. If RBI starts buying dollars from the market, it will release rupee liquidity in the system, easing the pressure on banks.

“Actual monetary conditions now are much tighter than what they were when the repo rate was at the same level last time. The transmission is thus also more effective," said Malik.

RBI has raised its policy rates five times this year. The surge in bond yields is also directly linked to the tight liquidity condition. However, dealers expect the yields to have hit the highs and should come down from these levels. “Rates have peaked mostly in the government bond side," said Maneesh Dangi, head of fixed income for Birla Sun Life Mutual Fund, which manages Rs67,421 crore in assets.

Indian banks are able to borrow money from RBI because they have a surplus in government bonds they can pledge with the central bank. Banks are required to invest 25% of deposits in government securities. This is called statutory liquidity ratio (SLR). “Currently there is about 6% of surplus in SLR holding, though concentrated in certain pockets," said Harihar Krishnamurthy, head of treasurer at FirstRand Bank Ltd.

Ashwin Ramarathinam and Bloomberg contributed to this story.