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Behold Dr. Rajan; Bond Tourists are back... - Outside View by Arvind Chari

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Behold Dr. Rajan; Bond Tourists are back...
Jun 13, 2014

India needs to really think deep and hard on what kind of investments it should want into its capital markets from foreign sources.

For years, we have had an issue of too much short term money coming into the Indian Equity markets; either through the opaque 'PNs - Participatory Notes' and directly from the self - anointed 'FIIs - Foreign Institutional Investor - aka foreign brokerage houses.

These so called 'FIIs' with whom the finance ministry and SEBI so willingly meet up to "encourage investments by foreigners into Indian markets"; are not 'Institutional Investors' but equity brokerage houses. Goldman Sachs; Morgan Stanley; Credit Suisse; HSBC; Deutsche Bank; Citibank; Merrill Lynch and the rest as "FIIs" are all essentially brokers who run 'proprietary positions' from their off-shore arms.

We have seen its impact on the Indian equity markets many times in the past. Short term ; proprietary investments by these very 'FIIs and their PN clients" have left Indian shores on the first sign of trouble; leading to enormous and often times needless volatility.

In 2007; the then RBI governor; Dr. Reddy who could see through all this; banned PNs in Equity markets. Since then SEBI opened up and relaxed the investment registration criteria; and made it somewhat easier for the 'Real Money - Long term Pension; SWFs; Endowments' to invest into India. The usage of PNs also since has dropped considerably.

The Indian bond market, in contrast was completely shielded till 2008 from foreign investments. Post the Lehman crisis; gradually the limits were eased under the watchful eye of the central bank. And investments gradually picked up. The initial investments were dominated by foreign banks and were focused largely into very short tenor assets. Slowly, we saw some the participation of funds; asset managers and also central banks investing into the Indian assets.

The big surge came between 2010-12; as India opened up the limits significantly to fund its growing Fiscal and Current Account Deficit. FII investments in Indian Bonds (Government and Corporate) rose from US$ 8 bn in December 2009 to US$ 17 bn in December 2010 to US$ 33 bn in December 2012.

It is of course of no coincidence that this period was the period of a global liquidity boom perpetuated by the Quantitative Easing (QE) policies of the US Federal Reserve and later on the European Central Bank (ECB). It is thus not surprising that a majority of investments were still dominated by offshore arms of Foreign Banks. And yet not surprising that the names consisted of the very same Equity 'FIIs'. And more so, they were carrying out what they very well know and do 'Leveraged Carry trade'.

For the bond markets; the moment of truth was May of 2013; as the US Fed indicated QE tapering; foreign banks did not taper; they actually dumped Indian bonds in manic hurry. From a peak of USD 37 bln in May 2013; FII investments dropped to USD 24 bln by October of 2013.

The RBI of course panicked in July 2013 and then wreaked further havoc in the bond markets which eventually resulted in the mayhem in the currency markets in August 2013.

Chart I : Foreign Investments in Indian Bond Market ; (USD Million)
(Source : SEBI)

As the Indian rupee and bond markets stabilized with the measures taken by RBI under Dr. Rajan; we are once again witnessing massive investments by foreigners in the Indian bond markets. FIIs have invested US$ 10bn since January till June 6th 2014. Which is a good sign. Sentiment is positive; macros have stabilized. But the worrying thing again is the nature of these flows.

A break up of the inflows seen suggests that it is once again dominated by the short term 'FII - Foreign banks proprietary investments'.

Between November 2013 and February 2014; FIIs invested 20,000 crs in Treasury Bills (money market instruments with a maximum maturity of 1 year). In March, on a small hiccup from some EM countries; the rupee started to depreciate and we saw massive selling of T-bills by these FIIs; thus leading to further sell-off in the rupee.

The RBI managed to stabilize the rupee and immediately issued notification to ban FIIs from investing in government securities of less than 1 year maturity and capped investments in Commercial Paper (CPs); to discourage short term investor.

As a message to the global investing community that India does not encourage 'Bond Tourists' but wants 'Bond Residents' ; it also allocated a further USD 5 bln limits in government bonds to long term investors like Pension funds; Sovereign Wealth Funds; Central banks etc by carving it out from the USD 25 bln limit which was available for other investors.

We were extremely pleased with the move as India needs only long term money to come into the bond markets. Indian bond markets are attractive; rates are high; markets are liquid but it requires depth . And it requires long term funds to help develop its infrastructure.

And thus Long term foreign investors and other 'real' money investors need to be encouraged to patiently participate in the long term development of the Indian bond market.

But the so called 'FIIs' are back at it again. With the carry on Indian bonds remaining attractive and the INR remarkably stable; the foreign banks proprietary off shore arms have found it difficult to stay away.

The ban on T-bills and less than 1 year maturity bonds has made them to buy government bonds of just above 1 year maturity. Between March and June (till date); although t-bill investments have fallen; but buying in governments bonds has been to the tune of Rs 300 bn.

Of these; investments by long term investors has been about Rs 35 bn and there were some investments by IFC (arm of World Bank) on the back of their global rupee bond issuance. We estimate that a majority of the rest of investments have come from our 'FII prop bank friends'.

Market trading reports and the reported data on the NSE for all government bonds above 1 year and maturing till 2016 reveals that close to Rs 250 bn of such bonds have been traded since April. A chunk of these we know were bought by these foreign banks FII arms.

This thus defeats the RBIs purpose of keeping Indian bonds limits free and open for long term investors and long term asset managers; funds; insurance companies.

Given the ability of these foreign bank FIIs in investing large sums of leveraged money in a very short period of time; they have completely consumed the available free limits for investments and more so have put the entire bond market and currency market at risk of another episode of volatility on the smallest event of risk aversion. The RBI needs to wake up and attack this trend on an urgent basis.

The fact that long term investors (both in Equity and Debt) remained invested through the crisis in the summer of 2013 is an indication that they believe in the long term potential of Indian markets and thus it is imperative for Indian policy makers to encourage these investors at the cost of the short term carry investor.

The RBI, SEBI and Ministry of Finance needs to really consider some urgent; drastic and unpopular steps to rid the Indian markets from the excessive dependence of these short term foreign proprietary investors. Our suggestions:
  • Under the existing FPI regime; carve out a separate category for all proprietary investors - investors who invest their own capital; like foreign banks; proprietary arms of foreign brokerage houses etc..

  • And have a separate; smaller; quota driven; restricted limits in both equities and debt for this category.. at a level which can be easily managed by the policy makers from a risk management perspective.

  • Stop interacting with this category of investors from a policy guidance perspective as FIIs. When the press reports that the 'Indian finance minister meets with FIIs in Delhi' . It is with these very investors that they meet. Not the long term institutional investor.

  • The 'real' long term FII is of course and obviously not in India.
India is a destination with great potential but Indian policy makers clearly need to do a lot more to attract the large pools in trillions of dollars of 'long term patient' money available with Pension Funds; Foundations; Universities; Sovereign Wealth Funds of the world.

The political mandate that we have offers the policy makers all the leeway to change the direction and the nature of the development of our capital markets.

Arvind Chari is Head Fixed Income & Alternatives at Quantum Advisors Pvt Ltd and advises two India dedicated off-shore India fixed income funds. Arvind was previously the fund manager for the Quantum Liquid Fund and the Quantum Equity Fund of Funds at Quantum Asset Management Company Pvt Ltd.


The views expressed in the Article are the personal views of the author, Arvind Chari and not views of Quantum Advisors Private Limited (QAS). QAS may or may not have the same view and does not endorse this view. The views expressed here in this article are for general information and reading purpose only and do not constitute any guidelines and recommendations on any course of action to be followed by the reader. The views are not meant to serve as a professional guide / investment advice / intended to be an offer or solicitation for the purchase or sale of any financial product or instrument. Information sourced from third parties cannot be guaranteed or was not independently verified. Whilst no action has been solicited based upon the information provided herein, due care has been taken to ensure that the facts are accurate and views given are fair and reasonable as on date.

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