Why have FPIs been selling heavily into Indian debt?

Why have FPIs been so wary of debt investing in India? In fact, there are a number of reasons for the same, let’s check out.

July 31, 2020 10:37 IST | India Infoline News Service
If you have been observing the FPI flows in the year 2020, you would have noticed that selling in Indian bonds has been consistent and relentless. March was an exceptionally bad month when FPIs literally sold out of Indian equity and debt. However, even as equity flows recovered post March, outflows in debt continued. Why this dichotomy?

Data Source: NSDL/CDSL

We have considered 7 months of data for the above analysis excluding the last week of July. FPIs have sold Rs106,476cr cumulatively in debt since the beginning of January 2020. Even after the huge sell-off in March, there has hardly been any respite on the debt front. Why have FPIs been so wary of debt investing in India. In fact, there are a number of reasons for the same.

Sovereign ratings are a worry for debt

In June this year, Moody’s downgraded India’s foreign currency and local currency long term issuer rating from Baa2 to Baa3. Just to give a perspective, this rating of Baa3 is the lowest investment grade assigned. Any downgrade from here will push India into Speculative category and it will become tough for Indian companies to raise debt abroad.

Of course, Moody’s had upgraded India’s ratings in 2017 while S&P and Fitch had held India at the lowest investment grade. However, Moody’s also went to the extent of downgrading the outlook for India to Negative on account of the likely COVID growth shock. This puts bond investing in India at risk as any downgrade will result in a fall in bond prices.

A sharp scale up in fiscal deficit is leading to selling in debt

Another key reason driving the selling in debt is the risk of a much higher fiscal deficit. The government had already expanded the fiscal deficit this year to 3.5% of GDP. But the way the government has tried to infuse nearly $300 billion as COVID stimulus, the worry is that fiscal deficit could get closer to 6% this year and put pressure on yields once again. This is evident from the fact that FPI utilization of debt limits is low in all categories.
Category of Debt Upper Limit Actual Investment Utilization (%)
G-Secs (General) Rs234,532cr Rs94,217cr 40.17%
G-Secs (Long Term) Rs103,531cr Rs25,591cr 24.72%
State Dev Loans (General) Rs64,415cr Rs702cr 1.09%
State Dev Loans (Long Term) Rs7,100cr Nil 0.00%
Corporate Bonds Rs429,244cr Rs154,271cr 35.94%
Data Source: CCIL / NSDL

Clearly, the fiscal deficit concerns are keeping the FPIs wary of Indian debt and this applies to government securities as well as corporate bonds. While FPIs have just about used up 40.17% of the G-Sec general category, they have used less than 36% of the corporate bond limit. Of course, they are virtually absent in state debt, due to viability concerns.

It is all about negative real interest rates

If you really want to know about the one reason why FPIs are selling so heavily into Indian debt, it is all about negative real interest rates. The nominal rate is the yield on the bonds that bond investors actually realize. However, when that is adjusted for inflation, you get real rates. Just over 1 year back, India had real interest rate levels of nearly 4% making Indian debt very attractive to FPIs. However, in the last few months, yields have fallen to as low as 5.82% on the benchmark 10-year G-Sec while inflation is hovering well above 7.5% on an average. Check the comparative graph of real interest rates to get a perspective.

Chart Source: Bloomberg

The above chart is self explicit about the reason why FPIs are selling into Indian debt. With real rates in India at (-2.30%), there is hardly any incentive for global investors to buy into Indian debt. They can get much better real yields in developed markets like Japan, Canada and UK. With bond yields likely to respond to interest rates, this real rate conundrum can be resolved only if inflation is brought under control.

Finally, currency also plays a key role

Exactly one year back, the Indian rupee was trading at Rs.69/$. Since then, the rupee has depreciated to Rs.74.80/$, representing an effective depreciation in the rupee of 8.4%. That means; even if the Indian debt paper pays them 7% yield, they literally earn negative returns in dollar terms. Indian rupee has been one of the worst performing currencies among emerging markets and concerns over the rupee have only exacerbated matters for FPIs.

FPI selling in debt has been consistent since the beginning of 2020. This can be partially attributed to COVID driven slowdown but it is also due to the sharp transformation in real interest rates from positive to negative. For FPIs to turn net buyers in Indian debt, they need the lure of lower inflation or a stable rupee. Both look fairly contentious at this point of time!

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