FPI Debt Limits - To Be Or Not To Be

There are many subplots in the ongoing Indian government bond market soap opera. One, which also has a bearing on our currency markets, is the debate on whether Foreign Portfolio Investment (FPI) debt limits should now be increased to bridge a potential supply/ demand mismatch for bonds. This is a touchy topic that excites passionate, ideological debates. 

While this is an immediate issue, it is worth stepping back and reviewing the overall context of portfolio investments. What is the current mix of portfolio investments in equity and debt markets? What has been the return to FPI investors under each asset class? How volatile have the flows been, and how can we make them more stable? Given all this, what could be the approach towards FPI debt limits going ahead?

Taking stock of FPI investments

Equity

As of January end, FPI equity assets under custody (AUC) stood at INR 29.2T ($448B). This constitutes over 20% of NSE total market capitalization, 40% of NSE NIFTY total market capitalization, and a staggering 72% of NSE NIFTY free-float market capitalization. There is some basis to the suspicion that a substantial portion of India Inc. is owned by foreign entities. 

On average, FPI investors into Indian equity have reaped good returns for the risk assumed. In all, INR 8.8T of net FPI equity inflows have grown to the current INR 29.2T of AUC, at an internal rate of return (IRR) of 13% in INR terms, and about 10% in USD terms. This does not consider the dividend payouts that have accrued to investors in the interim, so the actual returns are even higher.

Debt

In contrast, as of January end, FPI debt AUC stood at INR 4.6T ($71B), or 4.3% of total outstanding government and corporate bonds. FPI into government debt alone, at INR 2.4T, constituted 3.2% of the total INR 74T of outstanding central and state government debt.  

FPI investors in debt have naturally seen lower capital returns compared to equity investors. In USD terms, the IRR on debt investments is negligible. Of course, investors have collected regular INR coupons over time.

Contrasting debt and equity portfolio flows

If we ran a business that is projected to grow at say 12% per annum, with debt available at say 8% per annum, what mix of equity and debt financing would we opt for? This would depend on several factors, but at first glance, it is difficult to make the case that debt should be the stepchild to equity. 

India’s situation is somewhat similar. Our economy is growing at a nominal rate of about 11-12%, government debt is available at 7-8%, and yet, we have opted to raise six times more overseas portfolio equity investments than debt.

Of course, remaining shareholders and promoters benefit from the spike up in equity prices that FPI equity participation brings in. 

However, this mix of 6:1 in favor of portfolio equity flows should excite a policy debate. We seem to have opted to sell early ownership of our family silver to portfolio investors, while keeping significantly cheaper portfolio debt under check.  

Here is a controversial hypothesis – over the past 25 years, a conservative RBI that governs much of debt markets has ensured portfolio flows into debt remains under check. On the other hand, a liberal SEBI has opened the gates to welcome portfolio flows into equity, the area under its control. 

Between them, perhaps the country has been left with a sub-optimal mix across portfolio equity and debt flows. 

The counter-arguments

There are strong (and passionate!) counter-arguments against the above suggestions.  First is the contention that equity investments are invaluable as the most long-term commitments possible. Second, portfolio flows into debt are inherently more volatile, and portfolio debt inflows make us vulnerable to sudden sharp reversals. After all, in June 2013 during the Fed taper tantrum, we saw INR 330B of FPI debt outflows, thrice more than FPI equity outflows. 

There is some merit to the counter-arguments, but only some.

Long-term equity investments are indeed invaluable. It is moot however, as to whether portfolio investments into equity markets translate into productive investments as much as say FDI does. In fact, while the flows into equity markets last year have increased wealth and provided exit to some investors and promoters, their translation into fresh productive investments is just not obvious. On the other hand, one could equally argue that by bringing in portfolio debt flows into say government debt, we are freeing domestic savings for deployment into long term productive investments. At any rate, this “equity is more valuable than debt” argument by itself will struggle to justify a 6:1 mix in favor of early ownership sale to foreign entities. 

The higher volatility of debt flows is a valid observation. But this argument begs the question – why are debt flows so much more volatile than equity flows?

One can think of two reasons – one past, and one continuing. 

First, in the past, short-term debt FPI (say into 6-month T-bills) could be misused merely to capture onshore-offshore FX arbitrages. Such flows were always susceptible to volatile reversals, particularly when the mood towards India soured. However, this element was clamped down when RBI stipulated that any FPI debt investment should have a minimum residual tenor of 3 years. 

The other large continuing reason is the fact that Indian debt is not part of relevant global emerging market bond benchmarks such as JP Morgan and Citi bond indices.  

Indian equity, in contrast, is part of MSCI Emerging Market Index. Global emerging market equity fund managers are tracked against this model portfolio that includes Indian equities. This ensures some minimum stable demand for Indian equity, irrespective of fund manager views on India. 

On the other hand, portfolio managers have exercised their discretion to hold $71B of India debt, despite it being outside their model portfolio. This is gratifying, but is also a cause of immense concern. Any tremors anywhere in the world, and fund managers would be under pressure to reduce these off-benchmark Indian investments. The inherent vulnerability of debt FPI to sudden reversal continues.

Inclusion into global debt indices

So surely, one way of reducing FPI debt flow volatility would be to work on debt index inclusion? To be fair, MOF and RBI have explored the issue in the past. The immediate stumbling block was that for inclusion into global indices, the benchmark administrators typically insist that there should be no limits on possible foreign ownership of Indian bonds.

MOF and RBI have balked at the prospect of opening up Indian government bonds to unlimited foreign ownership. It would mean a need for strict macroeconomic discipline – overseas investors can punish us on wayward twin deficits for instance. Of course, such discipline and accountability might actually serve us well in the medium run! 

But without prejudging what the solution could be, I would suggest that the search for an acceptable means of debt index inclusion should continue. The process will take a long time (China has been working on this for years now), but the prize at the end of the tunnel would be worth it.

One via media that might meet both Indian concerns and those of the benchmark administrators is opening up specific bonds to FPI, without limits. As an example, there could be no restrictions on FPI owning any amount of say the bellwether 6.79% 2027 and 7.17% 2028 bonds. Given these bonds have limited outstanding stock, from India’s perspective, there is a de facto limit on overall bond ownership by FPI.  The benchmark administrators and select FPI investors seem to be okay with this arrangement as well. 

The specific solution above may or may not work. However, as mentioned before, we have to continue to work on finding a way out, together with the index administrators and other stakeholders. If we could start to count FPI debt flows as near stable, the benefits to our economy can be immense. It can help correct the imbalance in portfolio flows, instill discipline in our macros, and help open one more door to attract sustainable, long-term global savings into India. 

Impact on currency markets

If we do manage to find a way of making FPI debt flows more stable through index inclusion, we could address some of the potential demand/ supply mismatch for government bonds. Looking at the experience of other countries, debt index inclusion could bring in $20B of onetime stable flows, besides additional annuity flows. This could ease the pressure on local banks and financial institutions to support the government’s borrowing program, and instead free up our domestic savings to be directed towards productive investments. That seems a more efficient and logical route of deploying domestic and foreign savings, rather than opting for the reverse – i.e., using domestic savings to fund government debt, and foreign savings to fund long-term infrastructure. 

There would be an impact on our currency markets though. In part because of relatively high real interest rates in India, we have seen significant flows chasing the attractive “carry” of INR. This includes the $23B of FPI debt flows that came in 2017. As a result, despite our growing current account deficit (which is projected to hit a 5-year high this fiscal), in FY18 till January, RBI has purchased a total of $43B in the FX spot and forward markets. 

India is now close to hitting two of the three triggers that the US Treasury tracks in its semi-annual report on foreign exchange policies of major trading partners – our trade surplus with the US will be in excess of $20B, and the RBI could have intervened to buy foreign currency to the extent of more than 2% of GDP. At a time of populist global trade friction, it would not help to be seen as a currency manipulator by the Trump administration. 

Even otherwise, this bridging of a rising current account deficit with carry inflows is just not good from a financial stability perspective. What we need is for stable, FPI foreign exchange flows to come in, alongside a reduction of other speculative long INR positions – so that the inflows are absorbed not by the RBI, but by other entities. This needs a relook at the manner of RBI intervention in our currency markets, and a review of how our monetary policy impacts our currency markets (see https://ananthindianmarkets.blogspot.in/2018/01/the-great-inr-carry-trick.html)

Conclusion

Over time, we have had far more portfolio flows come into equity markets than our debt markets. We do need a review of whether this mix makes sense for a growing country like ours, both from a cost and a long-term strategic perspective. I would suggest this needs to be corrected going forward.

However, it is true that FPI debt flows into India suffer from inherent potential volatility, since India debt is not a part of global emerging market debt indices. This issue can and should be addressed, and that should give us comfort to increase FPI debt limits steadily over time.

Besides our debt markets, FPI debt flows have and will continue to have an impact on our currency markets. To ensure financial stability in the face of potentially more FPI debt inflows, we need a holistic review, including of market positioning, the impact of RBI intervention strategy, and the impact of monetary policy framework on currency markets.