Alarm bells are ringing once again for India’s funds industry following liquidity tightening by the central bank to prop up a weakening rupee and rein in a sprawling current account deficit.
Hopes had been high among asset managers that 2013 would be the year for fixed income funds to make their mark. Things had been going according to plan, too, with three 25-basis-point cuts in interest rates between January and May.
However, India is lumped in the emerging markets bucket that suffered billions in international investor outflows after US Federal Reserve chairman Ben Bernanke pointed in May to a tapering of its quantitative easing programme.
This global backdrop and India’s deteriorated external imbalances led to a sharp depreciation of the rupee to record lows against the dollar – down 11% over the past three months, notes HSBC. At the time of writing the currency stood at Rs61.10.
As a result, the Reserve Bank of India stepped in to hike the rate on the country’s marginal standing facility, used by banks to obtain emergency funds, by 200bp in July to 10.25% to lift short-term interest rates sharply.
This made it much more expensive for investors to short the rupee by borrowing US dollars, while holding the policy repo rate at 7.25%, notes HSBC. The rate spike sent corporates rushing for short-term cash, as reported by sister publication The Corporate Treasurer.
One result was that holders of money-market funds suffered negative returns in mark-to-market terms. (Mark-to-market rules were only recently introduced for liquid funds in cases where price fluctuation was 10bp or more.)
This was the equivalent of ‘breaking the buck’ in the US, and an estimated $8 billion in redemptions flowed from money-market funds in July, mostly withdrawn by commercial banks but also by conservative corporates, such as multinationals.
While much of this cash would have been used to retire high-cost debt, a large portion is understood to have been deployed in bank deposits and fixed-maturity plans (FMPs), allowing investors to lock in high yields (but providing miniscule margins for fund houses).
Sundeep Sikka, CEO of the $20 billion Reliance Mutual Fund, confirms strong interest in FMPs over the past three weeks. Reliance is one of the biggest players in this arena, with more than $3 billion in FMPs.
While Sikka says Reliance has placed greater emphasis on longer-duration bond funds for retail investors, he notes: “Everything cannot be profitable. There are times when you have to go with the approach that is right for the investor.”
Up to seven FMPs are closing on a daily basis in India now, says Nikhil Johri, CEO of BNP Paribas Asset Management India, which itself closed an FMP yesterday.
But he points to a broader impact for the industry: net asset values of fixed-income funds across the curve have turned negative, including money-market, short- and long-duration products. “Overall it has hurt investors across the yield curve,” he says.
“This was supposed to be the year for fixed income,” adds Johri. “The view was that the GDP growth rate in India was so low that interest rates would keep falling.
“But that has been shaken up by this [RBI] policy action. A lot of first-time investors [in fixed income funds] have been exposed and learned in a rather rude manner that the returns can go negative in a mutual fund.”
With equity markets providing no respite for fund houses – the Sensex is down 3% year-to-date and equity fund inflows are negligible – the outlook seems bleak.
Some managers are even comparing the severity of the situation to the one they faced in August 2009, when, with just three months’ notice, the Securities and Exchange Board of India banned fund houses from charging upfront commissions.
“Equity markets are rough, and fixed income was the hope for our industry,” adds Johri. “But that can easily come back as an asset class if some reversal happens over the next few months and the RBI rolls back what it has done so interest rates can start falling again.”
A big concern is that if redemptions hit the funds industry hard at a time when there are no inflows and liquidity is tight, asset managers may need to borrow. That would raise the prospect that the industry would have to call on the RBI to open a special lending window.
But the funds industry believes this situation will be short-lived. “I have not personally sold, because I do not see how you can continue at 10.25% for long,” says Indranil Sengupta, India economist at Bank of America-Merrill Lynch. “Clearly this monetary tightening has achieved nothing, the rupee is weaker, and stock and bond markets have both sold off.”
India is in monsoon season, when economic activity is low, he notes, but after September the weather improves, the festival season begins and activity picks up.
“If the RBI persists [in its policy action], that will hurt growth and the money management industry,” adds Sengupta. “Presumably they will try to wrap it up [before October], so there is still six weeks to go.”
The official consensus for GDP in India is 5.5-5.75% annual growth this year, although many fund houses have been downgrading their outlooks, with their consensus around 5%.
RBI in its monetary policy has indicated its measures to support the rupee are not permanent, with expectations that it will refocus its priorities on supporting growth once the currency stabilises.
"This may lead to aggressive monetary easing, which bodes well for longer duration fixed income funds," says Puneet Chaddha, CEO of HSBC Global Asset Management (India).
"We believe the short-term volatility on account of the currency concerns remain. However, over the medium term, monetary policy is likely to focus on growth, which in turn could regenerate interest in the long duration fixed income fund category."
Santosh Kamath, fixed income CIO at Franklin Templeton, also sees the positive side. “India is slowing down very sharply, and sooner or later these [RBI] policies will have to be withdrawn. Then rates will come down and investors will make their capital gains back.
“We could see this tightness for a couple of months, but the more it continues in the shorter-term, the greater the possibility of a sharper slowdown and the higher the chance of a rate cut,” he adds. “If you can take the pain for a couple of months, we could see decent gains on the longer end of the curve.”