During the current year, the inflows have again gathered momentum after some initial slowdown. The present increasing inflows have to be seen in the changing context of interest rate dynamics both domestic and globally. Globally, the downward journey of interest rates has either been stalled or reversed. With improved economic growth and inflation numbers, the Federal Reserve has hiked interest rates.
On the other hand, the widening trade deficit and fiscal imbalances have dampened investor interest in the US economy. Moreover, the dollar's weakness against the major international currencies has contributed to the strengthening of the rupee. According to the US Fed broad trade weighted index, the dollar has fallen by 15% from its peak in 2002 and is expected to fall further to get its current account deficit down to a manageable level of 2.5-3%.
The weakening of US dollar has improved the sentiments in the emerging economies and resulted in increased FII flows in India
Foreign institutional investments into India have crossed US $ 30 billion with no signs of slowing down. The net FII investments in the current fiscal have already crossed US $ 7 billion. In the month of November alone, net investments exceeded US $ 1 billion. Hitherto, these inflows were primarily invested in the equity market. However, in the past few months, some of these inflows haven also gone into the debt market. The total outstanding FII investments in debt are estimated at around US $ 1 billion.
While there are no limitations on FII investments in the equity market, SEBI has placed certain limits on FII investment in debt securities. A cap of US$ 1.75 billion has been placed on FII investments in dated government securities and treasury bills. In addition, a cap of US$ 500 million has been placed on corporate debt. These are primarily the two routes available for FII investment in debt.
The large FII flows whether in debt or equity has its inevitable implications for the conduct of domestic monetary policy and exchange rate management. In emerging markets, though the exchange rate is market determined, the central banks do intervene in the market in order to contain volatility and reduce risks on market agents and for the economy as a whole. Here too a difficult choice has to be made whether to intervene or not to intervene in the forex market and if the choice is made to intervene, what is the appropriate extent of such intervention. The intervention by monetary authorities in forex market cause unanticipated expansion or contraction of base money and money supply, which may not necessarily be consistent with the prevailing monetary policy stance. This may require the monetary authorities to consider offsetting the impact of such foreign exchange market intervention, partly or wholly, so as to retain the intent of monetary policy.
With regard to implications of FII flows on the debt market, the direct FII investments into debt market are expected to have a salutary impact in the form of incremental demand for debt pushing yields lower. This directly reduces the cost of borrowing for both the government and the corporate sector. However, given the size of the Indian debt market and the strict limits on FII debt investments, so far these investments have had a negligible impact on yield levels.
The real impact of FII investments on Indian debt market is not felt through direct investment in debt. Perhaps, the indirect impact of FII investments - in both equity and debt - through transmission mechanism in the economy outweigh the direct impact.
On the positive side, net FII investments result in forex inflows and an appreciating currency. These forex inflows directly add primary liquidity into the domestic economy. This liquidity injection into the domestic economy ultimately translates into increased demand for debt securities and hence lower yields.
Secondly, an appreciating rupee reduces the cost of imports. The impact of high global prices of crude and other commodities is to some extent mitigated by a strong rupee. Thus, FII inflows also contribute to reduction of imported inflation into the domestic economy. Inflation control is clearly on top of the agenda of the monetary authorities.
The RBI has been allowing the rupee to appreciate to avoid liquidity injection on one hand and to reduce imported inflation on the other. Inflation control is clearly getting priority over protecting export competitiveness.
Comfortable liquidity, strong forex reserves, appreciating rupee, lower demand of funds by the government coupled with inflation containment being on top of the agenda, augur well for the debt markets.
The writer is managing director, PNB Gilts Ltd. These are his personal views