Much of the foreign institution investor (FII) bid for Indian government bonds has been driven by the global hunt for yield that has seen fixed income investors expand their investment horizons in order to eke out returns.
However, since May 22, FIIs have sold INR113 billion (US$1.99 billion) worth of bonds in India, according to data from the Securities and Exchange Board of India (Sebi) and cited by Indian paper the Economic Times.
This foreign bondholder rush for the door corresponds almost exactly with signs from the US Federal Reserve (Fed) on May 21 that the world’s largest economy is considering ending up its quantitative easing (QE) programme and normalising rates.
Is this a coincidence? Probably not.
Since Fed chairman Ben Bernanke signalLed a possible end to QE, yields on the 10-year US Treasury have risen from 1.93% to 2.10% at the time of going to press. Bond yields in Asian domestic markets have also risen almost unanimously.
Yields on the Indian sovereign bonds, on the other hand, are relatively insulated from dollar rates. Since May 21, the yield on the 10-year sovereign bond has fallen from 7.35% to 7.21% on June 6, according to Bloomberg data.
This means that the yield pick-up versus US treasuries has fallen, and is likely to fall even further as lacklustre growth figures in India suggest the central bank is likely to cut rates again this year. Economists at Barclays, for example, expect the repo rate to be lowered by 75 basis points (bp) to 6.50% by the fourth quarter.
As if this was not enough to send FIIs running for the hills, the cost of hedging rupee-denominated debt is between 6.1% and 6.5% - high enough that investors are likely to find themselves with negative returns.
Leaving the currency unhedged is not an option for the faint hearted, as the rupee is notoriously volatile, and posted the biggest losses against the US dollar among all the major Asian currencies in May.
Liberalisation
So India finds itself in a position where it has little ammunition to tempt offshore investors onshore. To be fair, the sovereign has long resisted international participation in its bond market.
Onshore, foreigners only hold around 3% of the total outstanding debt. Offshore, India has only issued two US dollar bonds, one in 1998 and another in 2001, which were solely available to non-resident Indians (NRIs). Both have now matured.
However, regulators have been relatively proactive over the past year in terms of removing barriers to offshore bondholders, bringing down the withholding tax for foreign investors from 20% to 5% and increasing the FII quota among other incentives.
The general consensus is that the limits will continue to be relaxed as regulators monitor the impact of the inflows. However, this approach relies on the premise that FII demand will remain strong.
But if the fundamentals mean that international investors will find better value elsewhere, all of the good work in relaxing complicated regulations will go to waste, and India will find itself with persistent outflows rather than inflows to its onshore bond market.
In the near term, this is unlikely to upset either the government or the central bank too much. The sovereign can fund itself relatively easily onshore. Also, the RBI is concerned about the country’s rising debt, and is reluctant to expand its creditor universe from local to global. Compounding the problem is the high hedging costs that would be involved in a dollar bond.
Bankers believe that the Indian sovereign would likely pay around 8.5% for a US-dollar denominated five-year bond. This compares to 7.20% for a 10-year onshore bond. In the short term and as far as arbitrage is concerned, it would be irrational for the sovereign to fund through the offshore market.
Time for change
However, due to India’s persistent current account deficit and its infrastructure funding gridlock combined with consistently disappointing growth figures and the prospect of rising global rates; now is not a good time for India to remain passive as international capital passes it by.
The more inward-looking India becomes, the more it will struggle when it eventually needs to access the international markets. This will inevitably happen, either for infrastructure funding, or to help the state-owned banks raise Basel-III compliant capital, or simply because it needs to diversify its investor base.
Policymakers may be wary of giving off an image of desperation if they attempt to issue a dollar bond at the same time as international investors run for the doors. But the initial response to Bernanke’s speech is probably an overreaction and analysts believe QE will remain for around a year.
India should wait until markets calm down, but there is likely to be a window in the second half of this year and the first half of next, and India would do well to take advantage of this. If the sovereign is wary of diversifying its investor base too much, it could begin with another dollar bond aimed at NRIs.
This would help counter fears about a larger foreign investor base. It would also allow the sovereign to get a handle on the dollar market, which will give it more scope to issue again if necessary. It could begin with a short-term bond - say three years - and build up to longer maturities once the government becomes more comfortable.
A dollar bond would by no means be a silver bullet. Factors that negatively impact onshore bonds have the same effect offshore, especially for an emerging market sovereign such as India. But the benefits of access to the international bond markets are not to be sniffed at and issuing now would give India an opportunity to lock-in low US dollar rates as well as increasing its investor base.