There is some urgency to get in more foreign portfolio investments (FPIs) into the country
as this is a good source of forex given that the happy days of low current account deficit
(CAD) and accommodative monetary policies in the West are on the decline. Conditions
are going to be challenging as long as oil price hovers in the higher range of $70-75 per
barrel. In such a situation, getting in more FDI and FPI make sense. FDI limits in most industries are liberal and there have been peaks
in terms of inflows. But the pace of growth would be nominal. Besides, with growth opportunities improving in the West after a decade of
volatile stagnation post 2008, the focus would shift here. Most of them are talking of high infra spending, which will mean more private
investments that can cause diversion from emerging markets. As our FPI limits in debt were restrictive, it makes eminent sense to
encourage such flows.
The RBI has recently made them easier with FPIs allowed to invest in lower residual maturities of GSecs (which was earlier a minimum
residual maturity of 3 years) and corporate bonds (which can now be over 1 year). The FPI limits for the next year have been increased
by Rs 1 lakh crore for the combined set of markets.
One can see three advantages here. First, there would be higher dollar inflow, which helps the balance of payments and stabilise the
rupee. Second, more flows into the debt segment will give a boost to the corporate debt market. It may be recollected that the RBI has
been trying to manoeuver corporate borrowing to this segment and away from the banking system given the intrinsic ALM issues for
banks as well as the slow NPA resolution process. With the tenures for such investment being eased coupled with the higher limits
announced earlier by the central bank, the inflows would increase also in the corporate bond market. This could unleash a virtuous flow
of paper in the market.
Third, the general yields in the GSec market should come down as more funds flow in. Presently, yields in the bond market are high as
there are inflationary expectations, which will also mean that the RBI will not be lowering rates. In this situation, the 10-year yield has
been intransigent in the range of 7.7-7.9%. With more FPI flowing in, the demand for securities would go up leading to a decline in
yields, which, in turn, will assuage the market.
This is good part of the story and would work well in the short to medium term if it plays out. However, there are consequences of higher
limits for FPI. To begin with, FPI flows in the debt segment have been quite volatile in the last few years. The issue will get exacerbated
in case there is a sudden withdrawal, which can happen in a phase of two or three quarters. In 18 of the last 42 months, the flows have
been negative and when positive, have ranged from just a little above $ 1 million to $ 4.7 billion in a month. In such a situation, the bond
market will witness more volatility, which will create a different set of challenges.
Just like how inflows can moderate rates, a sudden withdrawal will lead to a spike in interest rates besides the exchange rate, which happens today. Such withdrawals can be due to global factors like higher interest rates in the US and may not be related to domestic factors. Hence, the level of volatility in the markets can be expected to increase as such flows will definitely not be on a fixed trajectory. As these yields get linked to other interest rates, corporates have to be prepared for the same. And so will the RBI with monetary tools of OMOs and the likes to stabilise markets.This can also be seen as an opportunity to build other markets like the IRS, where cover can be obtained on the interest rate differential and, hence, can help to develop this market. The RBI will, however, have to monitor both the forex and bond market as these flows swing in either direction. One must remember that as any country opens the door to more foreign influences, the risk of volatility increases. The steady appreciation of the dollar last year due to a weak dollar is a glaring example. We can expect some exciting times in future.
Just like how inflows can moderate rates, a sudden withdrawal will lead to a spike in interest rates besides the exchange rate, which happens today. Such withdrawals can be due to global factors like higher interest rates in the US and may not be related to domestic factors. Hence, the level of volatility in the markets can be expected to increase as such flows will definitely not be on a fixed trajectory. As these yields get linked to other interest rates, corporates have to be prepared for the same. And so will the RBI with monetary tools of OMOs and the likes to stabilise markets.This can also be seen as an opportunity to build other markets like the IRS, where cover can be obtained on the interest rate differential and, hence, can help to develop this market. The RBI will, however, have to monitor both the forex and bond market as these flows swing in either direction. One must remember that as any country opens the door to more foreign influences, the risk of volatility increases. The steady appreciation of the dollar last year due to a weak dollar is a glaring example. We can expect some exciting times in future.
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