Year 2020 saw net outflows from debt to the tune of Rs100,000cr. Most of this selling in debt came between March and May. But what is worth noting is that unlike equity flows, debt flows did not pick up post-May. Why is it that FPIs continue to remain sceptical about Indian debt even as they remain optimistic about Indian equities.
FPIs are sellingbonds in India but buying bonds in China
One thing that would irk Indian bond markets is that FPI flows into debt have been positive in China but negative in India during 2020. Chinese bonds are attracting record foreign inflows from global investors, almost at the same pace at which Indian equities are attracting foreign inflows.
To an extent it has to do with the respective approaches of India and China. While China went ahead and liberalized its bond markets to attract foreign inflows, India has been a lot more circumspect. There were a number of reasons for the same. The Indian government has been sceptical about foreign ownership of Indian debt. This was evident in the way the decision to issue sovereign bonds worth $5 billion was quietly dropped by India.
The Indian government has been wary of the impact debt could have on sovereign ratings and also on rupee value. The chart below captures how FPI flows into bonds have diverged in India and China.
The above chart captures the story of FPI flows into debt in the first 10 months of 2020. While $14.6 billion flowed out of Indian debt, FPIs infused $119.3 billion into Chinese debt. This gap becomes all the starkerbecause the gap is not about availability of limits. FPIs have hardly used up the limit available for investing in G-Secs and private debt in India. Then what explains this divergence?
Reason 1: India is yet to be included in Global Bond Indices
Like in the case of equities, even in debt there is a large chunk of inflows that are passive. These are the funds that track various bond indices and abide by the index composition rather than trying bond selection. Globally, the largest asset managers like Blackrock and Vanguard are predominantly investors in debt indices. That is where the dichotomy between India and China has arisen.
China initiated a slew of reforms to open up Chinesebond markets to global investors and also undertook structural bond market reforms. This enabled Chinese debt paper to get included in global benchmark indices. As of now, Indian debt paper is yet to become a part of global passive indices and till that happens, passive flows into Indian debt will be elusive. India expects that gap to be filled by mid-2021, but till that time the dichotomy between Indian flows and Chinese flows will remain.
Reason 2: Real rates slipped into negative on Indian bonds
The chart shows how repo rates and inflation rates moved in India over the last 21 months. Inflation has been more than the repo rate since October 2019 and the gap has only widened. One can argue that the bond yields are higher but even if you consider that, the inference would be the same. For example, currently 10-year bond yields are at 5.96% and the CPI inflation is at 7%, leaving a hug negative gap in real yields.
These negative real interest rates have been accentuated by the COVID-19 pandemic. It compelled the RBI to drop rates sharply but inflation worsened due to supply side constraints. That resulted in negative real rates for a sustained period. Global investors do not have any incentive to invest in EM bonds paying negative real rates.They can invest in 0% bonds across most of Europe. That has worked against FPI flows into Indian bonds.
Truth is: India needs global debt flows
That is a reality; like it or not. The current government plans to borrow a record Rs13 trillion in FY21 and the fiscal deficit is expected to scale 8% of GDP. Unless, Indian bonds give positive real rate of return, most global investors are not going to be interested. Unless, India embarks on aggressive debt market reforms, Indian bonds are unlikely to be included in global bond indices. That means; passive interest in Indian bonds will be limited. For the Indian government, the solution lies somewhere between aggression and conservatism. It is time to bite the bullet on the next phase of debt market reforms!