The down-slide in the Rupee was triggered in May 2013 when the United States Federal Reserve Bank (Fed) chairman, Ben Bernanke, indicated a potential reduction in its bond purchase programme later this year. The Fed chairman’s stance is supported by continual improvement in economic data in the US and has led many investors to believe that the Fed’s ultra-loose monetary policy (including near zero interest rates and quantitative easing (QE)) might be coming to an end.
This development in the United States matters to India as it raises concern about the outflow of the significant amount of portfolio flows that had entered the country over the last five years. Following the Federal Reserve Bank’s ultra-loose monetary policy initiated in early 2009 (the Fed had brought down the Federal funds rate to below 0.25% and introduced its bond purchase programme) global investors have been in search of yield and have looked at exotic destinations like India.
Data source: Securities and Exchange Board of India (SEBI)
Figure 1 shows that since early 2009, FII flows into India increased manifold. By April 2013, net FII investment in the domestic debt market had become 5.4 times its level in January 2009, while the level of equity investment increased 2.8 times. Even though the absolute level of debt investments is lower than investments in equities (note the difference in scales in figure 1), the acceleration in the flows within the domestic debt market is worth noting.
Meanwhile, the interest rate differential between US Treasuries and Indian Government securities increased from around 3.5% and 4.5% (in January 2009) to a decade high of 6.5% and 7.5% (in April 2013) for 10-year and 5-year maturities respectively (see Figure 2). A significant driver for FII investments in the Indian debt market over the last few years has clearly been investors’ search for higher yield, which might be coming to an end with now increasing US interest rates.
Data source: Reserve Bank of India, Federal Reserve Bank (U.S.)
Around $12bn of FII debt portfolio flows and $16bn of equity portfolio flows have already left the country since April 2013 (see Figure 1). This has been associated with more than 20% drop in the Indian rupee, around 9% drop in equity indices and more than 100bp rise in bond yields. The rise in bond yields was accentuated by the liquidity tightening measures taken by the Reserve Bank of India in the interim period.
In theory, the FII rout could continue as only 30% of the QE flows (combined debt + equity) that had come into the country since January 2009 have exited over the last three months. This however, may be stemmed if policy makers, especially on the fiscal side, take appropriate measures to win back investor confidence in the country. The task is all the more daunting as the risk premium offered to investors (indicated by Figure 2) is simultaneously decreasing.