Allowing higher FPI in G-Sec, cross-currency trade positive steps

Two aspects that stand out from the Reserve Bank of India's bi-monthly policy review on Tuesday – apart from the repo rate cut of 50 basis points to 6.75% – one, the step to offset the 25 bps phased reduction in SLR requirements of banks by increasing the cap on foreign institutional players (FPI) in government bond markets and second, the measures introduced to enhance the depth in foreign exchange markets by permitting cross-currency trading in three pairs, euro, dollar and yen.

SLR or statutory liquidity ratio is the mandatory government bond investments imposed on banks, which currently stands at 21.5% of the net deposits.

Banks have been permitted to hold in excess of this 25% of their net deposits if held until maturity, subject to some conditions. Both the limits will now be lowered by 25 bps every quarter starting January 9, 2016 till March 31, 2017.

"The RBI's decision to denominate FPI limit for G-Sec investments in rupee is a positive step. This will push yields down, spur dollar inflows and increase market liquidity," said K Harihar, head treasury at FirstRand Bank.

The move had an immediate impact in the secondary bond market where 10-year yields fell up to 12 bps before recovering partially by 2 bps to close at 7.61%. The bond markets reacted on the basis of Rs 1200 billion FPI inflows by March 2018. This indicates that the government's future market borrowings could come cheaper, provided the currency maintains stability and rate differential between US and India gives back a healthy 100 bps plus after factoring in hedging costs.

As of now, there may not be a case to generate FPI interests owing to rate differentials between US and India and the likelihood of Fed rate hike in December from the present near zero levels.

Foreign institutional players so long favoured government securities until the rupee began to depreciate leading to higher hedging costs in forward covers that shrunk rate differentials between US and India, not to forget the lowering phase of Indian rates since January this year.

The RBI's move, therefore, is subjective and based on futuristic assumptions, that the government thinks on the same lines to direct policies towards attracting foreign direct investments, encouraging foreign institutional participation in equities and robust exports all of which attract forex inflows and build enough buffer in forex reserves to maintain a balanced dollar-rupee parity.

Permitting cross-currencies in three pairs, namely euro-dollar, pound-dollar and dollar-yen is seen as a big boon to corporates, especially the SME segments. Trading in the three pairs will immensely reduce transaction costs and currencies will mirror global rates. So long, it was double-legged operations with rupee as a base to convert from one currency to another. Corporates had therefore first to convert their forex holding to rupee before switching over to another currency as all the four trading pairs were rupee based, namely dollar-rupee, euro-rupee, pound-rupee and yen-rupee. This has now been done away with. Through this move, retail participation in the three-pair forex currencies of dollar, yen and pound is also all set to be legalised as many retail investors were operating in these currencies through NRI accounts of close relatives and friends.

“Imports hit a high of around $550 billion in November 2014 and the transaction costs to switch from one currency to another are quite high. The new initiative of the RBI will see lower transaction costs and benefit SME players who will  switch over from OTC to other exchanges like NSE, BSE and MSEI,” said Ajay Kedia of Kedia Advisory.

“I see the volumes in these exchanges doubling once the fine print for trading in these cross currency pairs are announced,” he added.

With the turnover on the three exchanges set to leap from last week's Rs 1.22 lakh crore coupled with the latest merger of commodity regulator, Forward Markets Commission with the Securities Exchange Board of India on Monday (Sep 28), retail investors will now have a slew of financial products besides equities and bonds that offer attractive returns.