Governor: Bond Tourists Return

Indian policy makers need to really think deep on the kind of mutual fund investments that should enter India’s capital markets from foreign sources.

For years, we have had issues of too much short term money coming into the Indian Equity markets, either through the opaque ‘PNs – Participatory Notes’ or directly from the self-anointed ‘FIIs – Foreign Institutional Investor – aka foreign brokerage houses’.

These so called ‘FIIs’ with whom the finance ministry and SEBI so willingly meet up to “ encourage investments by foreigners into Indian markets” are not ‘Institutional Investors’ but actually equity brokerage houses of large banks and NBFC’s or brokers who run ‘proprietary positions’ from their off-shore arms.

We know what happened in 2008

We have seen the impact of short term money, or ‘tourist’ inflows on the Indian equity markets many times in the past. Short term , proprietary investments by these very ‘FIIs and their PN clients’ have left Indian shores on the first sign of trouble, leading to enormous and often times needless volatility. To mention a case in point, the sell-off in Indian Equities and INR in 2008.

The Indian bond market, in contrast, was completely shielded till 2008 from foreign investments. Post the Lehman crisis, the limits were eased under the watchful eye of the central bank. And investments gradually picked up. These initial investments were dominated by foreign banks and were focused largely into very short tenor assets. Slowly, we saw some participation of global funds, asset managers and also central banks/ sovereign wealth funds investing into the Indian assets.

The big surge came between 2010-12 as India opened up the limits significantly to fund its growing Fiscal and Current Account Deficit. FII investments in Indian Bonds (Government and Corporate) rose from around USD 8 bln in Dec 09 to close to 17 bln in Dec 10 approx to USD 33 bln in Dec 2012.

It is, of course, no coincidence that this period coincided with the global liquidity boom perpetuated by the Quantitative Easing (QE) policies of the US Federal Reserve and later on of the European Central Bank (ECB). It is thus not surprising that a majority of investments were still dominated by offshore arms of Foreign Banks. Enticed by the high rates on offer in India, they would borrow in the overseas markets and invest in Indian bonds to profit from the interest rate differential.

2013 was 2008 repeated only double the scale. And this time it was by Bond investors

For Indian bond markets, the moment of truth was May of 2013, as the US Fed indicated QE tapering, foreign banks dumped Indian bonds in manic hurry. From a peak of around USD 37 bln in May 2013, FII investments in Indian bonds dropped to around USD 24 bln by October of 2013.

The RBI panicked in July 2013 and then wreaked further havoc in the bond markets by raising short term rates by 300 bps (3%) which eventually resulted in the mayhem in the currency markets I am we remember August 2013, when triggered by bond outflows, the INR plummeted to as low as 68/$.

So, this time around it was FII investments in the Indian bond markets which became the source of volatility.

The Bond Tourists are back

As the INR and bond markets stabilized with the measures again taken by RBI under Dr. Rajan, RBI Governor we are once again witnessing massive investments by foreigners in the Indian bond markets. FIIs have invested close to USD 10bln since January till June 6th 2014. And worryingly, majority of these flows are dominated by short term investors in search for yields.

Between November and March 2014 FIIs bought about INR 200 bln in Treasury bills (upto 1 year maturity) and as RBI banned them from investing in less than 1 year securities. They then resorted to buying just above 1 year and upto 2 year maturity paper. Market trading reports and the reported data on the NSE for all government bonds above 1 year and maturing till 2016 reveal that close to around INR 25,000 crore of such bonds have been traded since April.

This thus defeats the RBI’s purpose of keeping Indian bonds limits free and open for long term investors and long term asset managers, funds, insurance companies.

Given the ability of these foreign bank FIIs in investing large sums of leveraged money in a very short period of time they have completely consumed the available free limits for investments and more so have put the entire bond market and currency market at the risk of another episode of volatility on the smallest event of risk aversion. The RBI needs to wake up and arrest this trend on an urgent basis.

RBI does not want these Bond Tourists

Dr. Rajan, RBI Governor seems well aware of this situation and termed the panic selling of FIIs in T-bills in March 2014 on a small panic in some Emerging Market countries, by naming them as ‘Bond Tourists’ and went on to ban investments in less than 1year instruments.

As a message to the global investing community that India does not encourage ‘Bond Tourists’ but wants ‘Bond Residents’, it also allocated a further USD 5 bln limit in government bonds to long term investors like Pension funds, Sovereign Wealth Funds, Central banks etc by carving it out from the USD 25 bln limit which was available for other investors.

We were extremely pleased with the move as India needs only long term money to come into the bond markets. Indian bond markets are attractive, rates are high, markets are liquid but it requires depth. And it requires long term mutual funds to help develop its infrastructure. And thus Long term foreign investors and other ‘real’ money investors need to be encouraged to patiently participate in the long term development of the Indian bond market.

But the so called ‘FIIs’ are back at it again. With the carry on Indian bonds remaining attractive and the INR remarkably stable, the foreign banks’ proprietary off shore arms have found it difficult to stay away and as mentioned earlier piled on to Indian bonds.

Are we in for a repeat of May-August 2013?

Although, India’s macro, political and external situation is better than that of the last year, we have seen how quickly sentiment towards India changes. And how these short term investors reverse their trades and start exiting.

The panic of 2013 saw short term interest rates being hiked and eventually even led to a rise in your home loan, auto loan rates. The depreciation in the INR also led to rise in the cost of the imports which meant increase in inflation and thus needed further rate hikes by the RBI. We could well be staring at an eventuality of some magnitude, if the short term FIIs again decide to sell their investments.

Contrast this to the fact that long term investors (both in Equity and Debt) remained invested through the crisis in the summer of 2013 is an indication that they believe in the long term potential of Indian markets and thus it is imperative for Indian policy makers to encourage these investors at the cost of the short term carry investor.

Encourage the Long term investor

In our view the RBI, SEBI and Ministry of Finance should really consider some urgent, drastic and even unpopular steps to rid Indian markets from this excessive dependence of short term foreign proprietary investors such as:

•  Under the existing FPI (Foreign Portfolio Investor) regime, carve out a separate category for all proprietary investors – investors who invest their own capital; like foreign banks, proprietary arms of foreign brokerage houses etc.
•  And have a separate, smaller, quota driven, restricted limit in both equities and debt for this category. This can be decided at a level which can be easily managed by the policy makers from a risk management perspective.
•  Reduce and eventually stop interacting with this category of investors from a policy guidance perspective as FIIs. When the press reports that the ‘Indian finance minister meets with FIIs in Delhi’, it is with these very investors that they meet. Not the long term institutional investor.

The ‘real’ long term FII is of course and obviously not in India.

The problem with having short term bond tourists playing in our markets is the fact that, like a tourist – when the visa expires and they return home, meaning that if conditions back home improve or say Indonesia becomes a more lucrative destination then these ‘tourists’ will pack their bags and head out – selling off their holdings.

The effect of this sell off will start to weaken the INR thus forcing the RBI to raise rates again or maintain them at high levels.

How will this impact you, the investor? Higher rates would mean that the cost of home loans and personal loans will be at higher levels, thus buying a house or a car on loan will become that much dearer, those on a fluctuating interest on their existing loans will also be adversely affected.

India is a destination with great potential but Indian policy makers clearly need to do a lot more to attract the large pools in trillions of dollars of ‘resident’ money available with Pension Funds; Foundations; Universities; Sovereign Wealth Funds of the world rather than relying on short term flows.

The political mandate that we have offers the policy makers all the leeway to change the direction and the nature of the development of our capital markets. We are of the hope that the regulators will take cognizance of this and ultimately frame policies that incentivize long term flows and therefore improving market conditions, which in turn will add stability to your portfolio.

Data Source: Bloomberg, Press Information Bureau website

Above article is authored by Quantum.

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