Dealing with US taper would be a lot easier if India was part of a global bond index, just like it is for equities
Even if the US recovery seems patchy at times, the overall improvement is steady enough to make it a near certainty the Fed will begin its taper soon, though we will know for certain over the next few days when the Fed meets. From minus 2.7% in Q1 2008, that is well before Lehman, US GDP grew 2.5% in Q2 2013; from 10.1% in 2009 as a result of the need to stimulate a collapsing economy, US fiscal deficits are likely to be down to 4.6% of GDP this year and are projected to fall further to 3.4% in 2014; employment, which contracted by 350,000 jobs in May 2009, has been growing steadily at around 165,000 new jobs per month for the last 3 quarters.
While US interest rates have already started rising in anticipation of the taper, how much they will rise will depend upon the Fed’s projected GDP rates for 2015 and 2016. Which means the rupee is likely to be quite volatile over the next few days. The extent of the volatility will be determined by how much money flows out, and that, in turn, will be determined by the market’s perception of how much US interest rates, currently 2.78% for 10-year paper, will rise over the next year—a 50-75 bps rise is likely in the next 6 months.
The latest PMEAC forecasts, in this connection, are interesting. Unlike the finance ministry, the PMEAC view is that even if the CAD is contained at the $70 billion the finance minister has projected for FY14, India will still have a shortage of $8.6 billion on the inflows side, necessitating a drawdown of reserves by this amount. This, though, could turn out to be an under-estimate since, if there are FII withdrawals, the situation will be very different.
Between May 22 when the Fed first began talking of a taper, and now, $10.41 billion has flown out of debt investments made by FIIs; given that FIIs still have $10.6 billion invested in Indian debt, there is a chance a part of this could also flow out.
What’s interesting, however, is that in contrast to debt money, just $1.6 billion flowed out in terms of FII money in equity since May 22—that’s a very small fraction of the $145 billion that FIIs have invested in India since FY01. There are various explanations for why FII outflows have been so limited. The first is a Hotel California kind of explanation, that were they to exit now, FIIs would get hit by both the fall in the Sensex as well as the rupee’s fall—so, they can check out any time they like, but they can never leave! In which case, when either the rupee or the Sensex stabilises, you could have a situation of the FIIs wanting to leave.
The other reason why FIIs have not left, and that looks a lot more likely, is because contrary to what many believe, this is not hot money, it is very largely ‘long only’ money. Linked to this is the manner in which performance of FII money, more accurately the performance of fund managers for FII money, is measured. Global fund managers typically benchmark their performance to the Morgan Stanley Capital International (MSCI) Index in the same way that Indian fund managers mark themselves against the Sensex or the Nifty. So, if the India weight in the MSCI Emerging Market Index is 5.9%, fund managers won’t want to be completely out of line with this. If they are not happy about India, they will be ‘underweight’ and have, say, 5% of their portfolio in Indian stocks, but not much more—right now, fund managers are by and large ‘neutral’, which means around 5.9% of their portfolio comprises Indian equity.
This is also why it makes sense for India to try and also become part of a global bond index. Just like the MSCI, around $2 trillion worth of debt funds benchmark themselves to the Citibank World Government Bond Index and, more relevant for an emerging market like India, about $200-250 billion of funds are linked to JP Morgan’s Government Bond Index-Emerging Markets-Global Diversified. Based on the size of the Indian GSec market (around $600 billion right now), India would most certainly hit the individual country ceiling of 10%—this means, in a business-as-usual scenario, India could look at getting at least $20-25 billion more of debt funds, it could be more as even those not tracking the JP Morgan Index could move in a similar fashion. And unlike the $10.4 billion that moved out of India since May 22, this will be money from long-term serious investors like Pimco who are likely to keep their India-weight at 10%, the India ceiling in the JP Morgan Index.
The single-most important criterion for inclusion in such indices, however, is that there should be no cap at all on FII purchases of government debt—the current cap is $30 billion, including a $5 billion one for sovereign wealth funds. The main reason why India does not want to remove the cap is because of the fear that, were there to be no caps and India had large FII investments in GSecs, there is the possibility that all FIIs could exit at the same time, causing a huge jump in bond yields at the same time while collapsing the rupee.
Since it is unlikely FII debt flows would leave as long as government policy remains disciplined, that in itself is a big reason to opt for it, because disciplined fiscal spend, for instance, would encourage more flows to come in. But, as in the case of FII in equity, this will encourage more ‘long only’ funds, so the chances of quick outflows are that much more unlikely. A study of fund flows across various markets by Standard Chartered confirms what is intuitively known, that the presence of global debt funds does not increase bond market volatility—look at India’s heightened volatility in recent months, and that is when the size of FII debt flows are so small and when there is a cap on such flows.
Apart from meeting India’s current forex needs, this would also allow India to achieve another important policy objective, of developing the corporate bond market. To the extent there is a steady stream of foreign bond funds available, the government can afford to reduce SLR commitments—currently at 23% of banks deposits. Once this is done, banks can then begin looking at investing more in corporate bonds.
The good news here is that the finance ministry has been holding discussions on this with various index-fund managers for several months, from even the time RBI Governor Raghuram Rajan was the chief economic advisor. If the finance ministry is on board, as is the RBI Governor, what are we waiting for?