2017 alone has seen FPIs pump .58 billion into Indian debt markets, more than thrice the .08 billion they have put in equity. 2017 alone has seen FPIs pump .58 billion into Indian debt markets, more than thrice the .08 billion they have put in equity.

Even as the Narendra Modi government prepares to unveil a package of measures to address the current slowdown, the elbow room to spend more to boost the economy may be far less than in 2008-09, when the then UPA regime unleashed a fiscal stimulus in response to a global financial meltdown. The primary reason for this is the sizable holdings by foreign portfolio investors (FPI) in Indian debt, which wasn’t a significant restraining factor then.

Consider this. On September 15, 2008, when Lehman Brothers collapsed and triggered a worldwide economic crisis, FPIs held a mere $5.59 billion in Indian debt. But nine years later, on September 22, their outstanding net investment in government securities and corporate bonds was $72.76 billion. Out of this, $41.59 billion or over 57 per cent has come since the Modi government’s taking over on May 26, 2014 — a period marked by relatively low inflation, fiscal conservatism and a stable rupee that FPIs particularly appreciate.

How these very investors would react to any presumed deviation from fiscal and monetary prudence — whether through allowing higher-than-budgeted deficits or slashing interest rates — is a question that may well weigh on the minds of both the finance ministry and the Reserve Bank of India (RBI). There is a precedent. In 2013, between May 22 and August 31 – coming after the US Federal Reserve, for the first time, indicated a phase-out of its massive global liquidity-infusing bond buying programme – the FPIs sold $10.4 billion worth of Indian debt, which was a major cause of the rupee’s exchange rate against the US dollar plunging from 55.5 to 68.5 levels in just over three months. Interestingly, during that “taper tantrum” period, their net sale of Indian equities was only $2.77 billion.

“When FPIs buy equity, it’s generally for the long term because you are betting on the future earnings of individual companies and hence prepared to stay invested. But in debt, you are simply betting on two things: interest rate differentials and the exchange rate. There’s always the threat of stampeding out, then, at the first sign of any risk on those fronts,” said a senior research analyst with a top global investment firm.

2017 alone has seen FPIs pump $20.58 billion into Indian debt markets, more than thrice the $6.08 billion they have put in equity. “Today, yields on 10-year Government of India securities, at 6.66 per cent, are way above the 2.25 per cent from US Treasury notes of the same tenure. With a stable rupee, it allows for carry trade, wherein you borrow at the current low global rates and invest in an asset that, in this case, gives a 4 per cent extra return even after factoring in 0.25 per cent hedging cost,” the analyst pointed out. This wasn’t so four years ago when, even with 10-year Indian bond yields at 8.9 per cent and comparable US Treasury rates of 2.8 per cent, the sheer cost of hedging against currency depreciation made “carry trade” far less attractive.

There are two possible sources of disruption of FPI flows into Indian debt now. The first — on which the government here has no control — is the prospect of global interest rates hardening, especially with the US Fed expected to further raise interest rates and also begin reducing the size of its bloated balance sheet. The second is if the Modi government or the RBI were to embark on a fiscal and monetary stimulus — this time in response to a domestic, as against global, slowdown — that is seen to undermine macroeconomic stability.

Many foreign brokerages have already expressed concern over deteriorating state finances. This, even with the Centre’s own fiscal position showing improvement under the Modi government, has led to general government deficits being still way above their 2007-08 lows (see graph). “Recent farm loan waivers announced by various states have made matters worse. If the Centre, too, decides to loosen its purse strings, that’s not a good sign,” noted another bond trader. An indication of what can happen was seen last Thursday, when the rupee fell 53 paise against the dollar (its biggest single-day loss in more than four months) and yields on the ten-year benchmark government paper rose from 6.58 to 6.68 per cent.

So, can there be a repeat of June-August 2013, with FPIs deciding to massively unload Indian debt? “It’s quite unlikely they are going to panic this time. These investors will exit only when they think macroeconomic stability is really being compromised,” pointed out Sajjid Chinoy, India economist at JP Morgan. With foreign exchange reserves at a record $402.51 billion as on September 15 and the Modi government’s overall credible track record of macroeconomic prudence relative to the UPA, India is much less vulnerable to portfolio outflows today.

Also, even at nearly $73 billion, the FPIs’ holdings amount to less than 5 per cent of total outstanding India government and corporate debt, whereas this ratio is roughly 21 per cent in listed Indian equities and 40 per cent of free-float market capitalisation. Other emerging market economies are much more exposed to FPI investments in domestic debt.

But either way, the perceived threat from “bond vigilantes” — mainly FPIs who protest against what they consider imprudent fiscal or monetary policies through large-scale bond sales — is likely to force finance minister Arun Jaitley to be far less adventurous today than Pranab Mukherjee back in 2008-09.

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