India’s capital markets regulator is beginning to catch the attention of international investors, and after a summer of disappointing data combined with worrying rule changes – this time policymakers seem to be getting it right.
On October 5, the Securities and Exchange Board of India (Sebi) eased regulations governing foreign access to the domestic bond market. The registration and investment process has traditionally been arduous enough to discourage many potential buyers, and investment restrictions have prevented the country’s bonds from inclusion into emerging market indices.
This has long been a buy-side complaint. Even China’s onshore bond market has been opening up at a faster pace than India’s. In the latter, laws remained stagnant largely because the government was reluctant to expose the onshore market to the kind of volatility that more open markets in the region are often subject to such as Indonesia.
But a surprise announcement from the US Federal Reserve on May 22 that its quantitative easing (QE) programme would be slimmed down this year hurt India badly, despite its cautious approach to foreign inflows. International investors, concerned by the country’s twin deficits, sold their holdings.
Over June and July, net outflows from foreign institutional investors (FIIs) totalled over US$10 billion. The currency weakened to an all-time low of INR68.85 against the US dollar on August 28 – versus a five year average of INR50. Policymakers reacted by furiously debating their options and announcing a continuous - and sometimes contradictory - stream of reforms, some of which were received well; others less so.
But almost five months later as the panic is dying down and a semblance of stability resumes, it is clear the fiasco has had two positive consequences for the onshore bond market. Firstly, India’s need for foreign capital has convinced Sebi to fast-track the removal of prohibitive laws that – without a reason for reform – may have remained in place for years.
On Saturday, the board approved draft regulations for what it calls foreign portfolio investors (FPI). This is an amalgamation of three existing investor classes – FIIs, sub accounts and qualified foreign investors (QFIs). Sebi approved dealers can register FPIs with the regulator as long as they comply with know-your-customer (KYC) requirements.
Prospective investors can register under one of three categories: the first is for government or government related foreign investors, the second is for funds and the third is for anyone else who wants to invest. The first two groups will be able to both issue and deal in offshore derivatives instruments, either directly or indirectly.
The second positive outcome is that the streamlining process coincides very well with a broad-based investor call that onshore rates have reached an attractive level. Ten-year sovereign bond yields could rebound to 8.20% within the next two months, according to some estimates – 42 basis points (bp) lower than they are at the moment. To put the figures in perspective, at the end of May the 10-year was yielding around 7.1%.
Current valuations combined with the fact that yields have likely hit a peak and the investment process has been simplified, means that long-term investors such as pension houses and insurance companies are likely to buy into the onshore market.
In addition, the central bank is likely to start open market operations (OMOs) in November, which is important for bond investor sentiment as it suggests that the central bank has finished – or almost finished – tightening the policy rate, which is currently at 7.50%.
In all, it looks as if Sebi is getting the situation under control. In the long run, this is a very good thing for the market as it has convinced some investors that the regulator is building up to a wider liberalisation.
The demonstration this summer that India’s closed bond market did it no favours relative to Indonesia’s – where almost 40% of government securities are owned by foreigners – will hopefully be sufficient to convince policymakers that an open market is no bad thing.
At the moment, the regulator has only moved part of the way towards making the country’s bond market an attractive investment destination for international capital. An easier investment route can only be so helpful if inflow volumes are kept unnaturally low.
If Sebi was to remove the investment limit for onshore government and corporate bonds, which is currently US$30 billion for government bonds and US$75 billion in total, this would make India eligible for inclusion in global bond indices. This in turn would lead to sufficient inflows to stablise the currency and give the central bank room to properly focus on monetary policy.
This summer was hairy for Indian policymakers to say the least and should be taken as evidence that positive international sentiment is essential for financial stability onshore. Investors, who have been wary of India for months, are finally thinking about coming back. Levels are attractive and sentiment has steadily improved following the appointment of a new central bank governor.
For India to open its doors to foreign investors would be a big step, but evidence suggests the payoff would outweigh the risks. Sebi is well lined up to take positive action and with a weakening banking sector, shaky finances and an election set to take place in the not too distant future, India’s authorities don’t have the leeway to miss an opportunity such as this.