A policy rate that is at a four-and-a-half-year high seems to have turned foreign investors into net buyers of Indian bonds after a gap of two years.
Foreign investors have bought $840 million worth of Indian bonds so far in 2023, in contrast to being net sellers in 2022 and 2021, data from depositories shows.
While the inflow isn’t much, the change in direction suggests a rekindled interest in local debt. What’s more, the latest policy statement by the Reserve Bank of India (RBI) indicates to some market participants that one more rate hike is up its sleeve.
The RBI increased the policy repo rate by 25 basis points to 6.5 percent on February 8. The rate has been increased by 250 bps since May 2022.
“The flow of FPI into debt depends on factors such as interest rate differential, growth prospects of a country, and stability in the exchange rate,” said Madan Sabnavis, chief economist at Bank of Baroda. “With the RBI being proactive and following what is being done in the west, the rates look attractive. India will be a better performer on the whole and the currency has been more stable and less volatile compared with other countries. That’s why we have scored. However, one cannot be sure if they will stay as it also depends on alternatives in the west and the overall quantum of available investible resources.”
Foreign investors sold an average $7-8 million every day in the bond market in 2021 and 2022. On a cumulative basis, they sold $1.6 billion in 2021 and $2.01 billion of bonds in 2022.
What also worked is the fiscal rectitude mentioned in the Union Budget for FY24, presented on February 1. The government's commitment to sticking to the predetermined fiscal trajectory has made foreign investors confident.
Another reason is the US Federal Reserve’s softer tone and smaller hike in the funds rate. Expectations are that the Fed’s hikes, if any, would be piecemeal from here on and it will begin to cut rates by the end of 2023.
On the other hand, the RBI is unlikely to ease its tight policy soon, given the renewed focus on sticky core inflation. That means the interest rate differential between the US and India could turn favourable.
“The recent increase in interest rates by the Federal Reserve and other central banks has made debt more attractive, with US Treasury yields reaching 4 percent. The RBI’s rate hike, combined with high nominal rates, such as the 7.30 percent yield on 10-year bonds, and a stable rupee, has made investing in Indian bonds even more appealing,” said Sabnavis.
While these factors explain the fund flows in February, bond investments were strong in January too.
Forex advisory firm IFA Global pointed out that hedging costs have come down and a stable currency is making investors confident.
“The cost of hedging has decreased, with a one-year forward yield of 2.15 percent. This is expected to be a significant factor in attracting investment inflows. Additionally, the spread between the forward yield and interest rate differential is currently lower than it typically is, further contributing to the favourable investment climate,” IFA Global said.
While a large part of foreign money is unhedged, long-term foreign investors hedge their investments to avoid surprises. Low forward premiums would encourage such flows.
That said, investors are watchful of the large government borrowing and the expected deceleration in economic growth in FY24. While dollars may have begun to trickle into the bond market, the continuity of those flows depends on global liquidity and India’s economic prospects. The jury is out on both.