Will India hike investment limits for global bond buyers?

Foreign investors still have plenty of pent-up demand for high-yielding rupee-denominated Indian bonds, even though their cumulative bond purchases are close to breaching the maximum permissible limit and capital inflows have slowed of late, according to fund managers and market experts.

It's easy to see why: with the benchmark 10-year government bond yielding 7.6%, Indian debt remains a highly appealing proposition for income-starved investors.

“With India’s growth fundamentals remaining strong and bond yields among the highest in Asia, we believe foreign investors will continue to be attracted to this market,” London-based Claudia Calich, emerging market debt specialist at M&G Investments, told AsianInvestor.

“I do not foresee the government raising overseas investor limits,” Vikram Aggarwal, assistant fund manager for fixed income at Jupiter Asset Management, told AsianInvestor. “I met with the central bank and finance ministry in January this year and neither suggested this change was imminent.”

Foreign portfolio investors in India’s bond markets – which include pension funds, insurance companies, sovereign wealth funds and mutual funds – invested around $22 billion in Indian debt securities (government and corporate) in 2017, after pulling out a net $6.6 billion in 2016, according to data from the National Securities Depository Limited (NSDL).

Foreign investors are permitted to buy rupee-denominated government debt on tap until those purchases reach 5% of the outstanding securities. This equates to about $28 billion. Similarly, local currency corporate debt can also be bought on tap until purchases reach 95% of the Rs2.2 trillion rupees ($32 billion) presently allocated to them. The remainder is then allocated via auction.

The latest NSDL data shows foreign investors have used up 94.17% of their limit on central government bonds and 98.2% of their limit in corporate bonds.

"The interesting part is that these inflows have occurred without India being a part of the major bond indices,” noted Mumbai-based Nilesh Shah, managing director of Kotak Mahindra Asset Management, a local fund house.

India does not figure in widely tracked bond indices such as Citi's World Government Bond Index or the Bloomberg Barclays Global Aggregate Index. Typically, when a country's bond market is included in such indices, it bestows an international seal of approval on that market and has the potential to attract millions of dollars from international investors as many of them benchmark their portfolios to these indices.

RISING YIELDS

That said, portfolio capital inflows into debt have moderated so far in 2018 and even reversed in February and early March. From January until March 13, foreigners invested just $160 million into Indian debt markets, NSDL data shows. 

Experts attribute that slowdown to the limited availability of local bonds for foreigners now that they close to their ceilings. But there are also some concerns over rising inflation and India's fiscal deficit. Concerns about a more hawkish RBI and rising consumer prices – Indian inflation was at 4.4% for February, above the medium-term 4% target set by the central bank – are leading to expectations that bond yields could climb higher.

If the foreign investment ceiling was increased, it would help to cool down local bond yields to some extent – the 10-year government bond yield has surged from around 6.45% in September to 7.77% in early March.

Jack Siu, Asia Pacific senior investment strategist for Credit Suisse, forecasts 10-year Indian government bond yields climbing to 8% in three months and to 8.2% over the next 12 months.

Those yields might be lucrative for investors but are not necessarily palatable for a government, which will have to issue around Rs6 trillion rupees worth of bonds to fund its fiscal deficit for the financial year starting April 2018.

NOT TOO SPICY

That all adds to the case for easing limits for overseas debt investors, but as this media report notes India has always been paranoid about "hot money" and regulators have tended to adopt a very conservative attitude towards foreign capital to ensure money flows in and out without destabilising the economy.

“India has a right to be cautious but it is erring on the side of being too cautious,” Calich of M&G Investments told AsianInvestor.

Asian countries have a mixed track record when it comes to foreign ownership of local bonds – while Indonesian and Malaysian bond markets are around 40% and 25% foreign-owned, respectively, just 15% of Thailand's bond markets are in foreign hands, according to data from AsiaBondsOnline.

There is no one-size-fits-all optimum market share for foreign ownership of securities, experts say. (In developed markets, even in this era of heavy central-bank bond buying, foreigners own about 30% of outstanding US Treasuries and just over 10% of Japanese JGBs).

“It’s important for each country to decide where its structural tipping point lies in terms of limiting its vulnerability to a foreign investor sell-off,” Credit Suisse’s Hong Kong-based Siu said. “This is especially true in markets such as India, where the fiscal situation makes it highly dependent on bond market financing.”

Other experts agree and think Indian authorities are right in exercising caution before throwing the doors wide open to global bond buyers.

“We cannot afford what happened in Southeast Asia or Russia, when foreign investors withdrew large amounts of money, ravaging those economies,” said Kotak Mahindra Asset Management's Nilesh Shah, referring to the Asian Crisis and Russian default of 1997-98. 

Shah said India should open its bond markets further only if it wants to be part of the global bond indices tracked by international investors, he added.

“But there is no room for incremental steps – that decision requires a big push and an acceptance of conditions that can make foreign investors more comfortable about making India a part of their core allocations,” he said.

Swing allocations, where money is invested when things look good and pulled out when things start to turn bad, will hurt an economy much more, Shah said.

That will require engaging with major index providers more intensively, as China did before its equities were included in global equity indices such as the MSCI.

For now, few experts think the Indian authorities are thinking about index inclusion, partly because they say India has historically only tended to introduce reforms when compelled by events rather than as a result of forward planning. As one local market observer who declined to be named put it: "The authorities only take action when their backs are pushed against the wall.”

Since the bond markets, while challenged, are not in dire straits, it seems premature to expect any major policy changes.