Open up debt market to curb Fx volatility

From an Indian foreign exchange market perspective, one of the highlights of 2016 was the net outflow of Foreign Portfolio Investors (FPI) exposure in domestic debt, of over $6.5 billion.

India has been far more open towards FPI investments in equity, rather than debt. While FPIs own about 23% of BSE Sensex and about 46% of BSE Sensex free float, FPI ownership in government bonds is 3% of outstanding. FPI equity investments are today worth over $350 billion, while FPI debt investments across government and corporate bonds is about $46 billion. As a country with immense growth potential, are we selling ownership cheap, as opposed to taking debt?

One strong argument made to justify the current mix is the volatile nature of FPI debt flows in India. Indeed, post the Federal Reserve taper tantrums of May 2013, we saw outflows of $8 billion from FPI debt in June and July 2013, while FPI equity outflows were only a third of that number.

Why are debt flows volatile? One argument advanced is the relative liquidity of the debt markets, as compared to equity markets. This is not necessarily borne out by evidence – liquidity in the equity scrips and bonds that FPI hold are comparable.

A less appreciated reason is membership of global indices. Indian equities are part of global indices such as MSCI. A portfolio manager's return is benchmarked against these indices, so she has an incentive to track and hold the constituent stocks to some degree, irrespective of the underlying view.

On the other hand, unlike some of its EM peers, Indian government debt do not form part of global debt indices. All FPI local debt investments are therefore bets outside of benchmark. At the first sign of volatility anywhere in the world, any debt portfolio manager would be tempted to reduce her non-benchmark India holdings.

One reason Indian debt is not included in global indices is our limits on foreign ownership of local debt. As a way out, we could open individual bonds to foreign ownership without limits, rather than the entire family of Indian government bonds. We would then meet our objective of effectively limiting foreign access into debt, while still giving portfolio managers benchmark bonds to invest in.

To reduce the volatility of FPI debt flows, we must work on index inclusion of our local debt.

The writer is regional head of financial markets for Asean and South Asia of Standard Chartered