What Drives FPI Inflows into the Indian Debt Market?

Lets begin this post by being a little pedantic, shall we? But before that, inline with tradition (we love nerdy humour on nerdverve), let’s poke some fun at pedants like us.

I present to you, exhibit A: “Gary the Grammar Cactus Will Never Find Love”.

This was forwarded to me by a friend (you know who you are) and made me laugh for days! Now that we’ve established that I will never find love, lets get down to business.

FPI vs. FII: Lets get pedantic

FII or Foreign Institutional Investor refers to an institution established or incorporated outside India, which proposes to make investment in securities in India. While the term “FII” was used commonly before, it has been replaced by FPI or Foreign Portfolio Investor now. Starting June 2014, a new investor class called FPI was created by SEBI by merging the 3 existing foreign investor classes - FIIs, Sub Accounts (of FIIs) and Qualified Foreign Investors (QFIs). Note: “Sub Accounts” include foreign corporates, foreign individuals, those institutions established or incorporated outside India and those funds/portfolios established outside India (incorporated or not), on whose behalf investments are proposed to be made in India by a Foreign Institutional Investor (FII). QFIs include foreign individuals, groups or associations resident in certain countries.

In common parlance (even in business publications actually), FII and FPI still tend to be used interchangeably, even though the correct term to use is FPI. Also note, the data referenced in Indian business publication is always FPI data (provided by CDSL and NSDL) even when referred to as FII data.

Remember, foreign portfolio investment by any single investor cannot exceed 10% of the equity of an Indian company, beyond which it is treated as FDI (Foreign Direct investment).  Total limit for FPI in an Indian company is 24% (of total equity) – this limit can be raised up to the FPI cap for the sector.

While I’ll talk about FDI in later posts, I’m going to quickly mention the key differences between FPI and FDI before we move forward. FPI refers to smaller stakes in Indian companies. FPI investors are usually passive, are not involved in management and strategy decisions of the company, and have a relatively shorter investment horizon. FDI investors on the other hand usually have controlling stakes in Indian companies, are involved in management decisions and tend to be long-term investors.

What drives FPI inflows into the Indian debt market?

The factors that drive FPI flows into the Indian debt markets are essentially the same that drive FPI flows into any debt market. I decided to focus on the motherland in this post simply to make this discussion topical and allow you to say at least a few smart things when you see your friends next.

I’m going to refer to the Jan-Apr 2015 period to underline these drivers.  (Our next post will deal with factors that are currently driving FPI flows out of India – what a difference a few months makes!)

Jan – Apr 2015: Huge FPI Inflows into Indian debt

The Jan-Apr period of this year saw huge FPI net inflows into the debt market (Rs 20,000+ Crores in Jan, Rs 13,000+ Crores in Feb, Rs 8,600+ Crores in Mar). A number of favorable factors combined to create this welcome state of affairs.

Note: Net FPI inflows for July were just USD 4 million, and for Sep till date, the figure is USD 227 million. These values don't show up in the graph above because of the scale.

·     Higher yields vs. developed markets. Bond yields (=coupon received/price of bond) in India are much higher vs. those in many developed countries. In the Jan-Apr period, the 10-yr US Treasury yield averaged 1.95%, while the 10-yr Indian government bond yield averaged 7.76%. The interest rate differential was 580 bps! (See charts below). Of course this higher yield had to be weighed against the higher risk that Indian government bonds embody vs. US treasury bonds. Per S&P, India’s sovereign credit rating is BBB- against the US’s AA+. The higher returns however were quite attractive early in the year despite the higher risk, due to a number of other favourable factors mentioned below.

·    Falling interest rate environment = mark-to-market gains. There are 2 ways investors make money on bonds. First is through the regular coupons payments they receive. This is called “carry” (i.e. yield of bond). The second is through mark-to-market (MTM) gains or capital gains. This happens when interest rates/bond yields fall, which causes bond prices to rise since bond price is inversely relate to yield (we’ll do a separate post on this sometime I promise). A rise in bond price means capital gains or MTM gains for the investor.

In the Jan – Apr 2015 period, the RBI cut the repo rate twice (Jan and Mar) by 25 bps each (to 7.5%), with more cuts expected by the market in the coming months. As a result, bond investors poured money into the debt market hoping to profit from capital gains.

·      Relatively strong, stable Rupee.  The rupee was amongst the best performing currencies viz-a-viz the dollar in the Jan-Apr 2015 period. A stable government with a reform agenda, improved macro expectations, a smaller current account deficit, falling inflation trend and expectations of rate cuts from the RBI, all led to strong FPI inflows (debt + equity) into the country. Given this backdrop, the RBI bought a massive amount of dollars to prevent the rupee from appreciating.

Let me explain how this works. When there are strong FPI inflows into the country, the supply of dollars increases vs. the available rupee supply, causing the rupee to appreciate vs. the dollar. This is bad for the Indian export industry since a stronger rupee tends to make exports more expensive for foreign buyers. In order to avoid this situation and prevent exchange rate volatility, the RBI usually buys dollars. This curbs excessive rupee appreciation and keeps the USD-INR exchange rate stable/within a range.

However, this tends to be inflationary. Why you ask? The RBI prints rupees in order to buy dollars thereby increasing the available rupee supply in the system. More money chasing the same amount of goods leads to inflation. To avoid this unintended consequence, the RBI does what is called “Sterilization”. Sterilization refers to the issuance of government bonds by the RBI to mop up the excess rupees released into the system when it buys dollars/ intervenes in the forex market.

Anyways, coming back to point, given huge FPI inflows into the Indian debt and equity markets in the Jan-Apr 2015 period, the RBI bought a massive amount of dollars in the same period, to prevent excessive appreciation of the rupee vs. the dollar. This kept the currency stable and was reassuring for foreign investors, who continued to pump in more money.

           

·      Steady Fed Funds rate and other (India-specific) factors.  While we’ve talked about the key drivers that helped attract FPI inflows into Indian debt earlier this year, there are many other factors that FPI investors consider while allocating funds. One of the most important is the Fed funds rate trajectory. In the Jan-Apr period, the Fed funds rate was steady with a hike not expected before June. When the Fed raises rates, interest rates in the US rise and the dollar appreciates, causing the interest rate arbitrage opportunity between India and US to narrow, which leads to FPI outflow from Indian debt.

Other India - specific factors such as strong macro fundamentals (vs. other emerging markets) and GDP growth, falling inflation trend, stable government and reform agenda etc. also played an important role in driving FPI investment into Indian debt during the Jan-Apr 2015 period.  

We’re going to end here, and talk about factors engendering FPI outflows (the situation today) in our next post.