By Arun Kumar Sharma —
Status: Not Started — The current limit of six percent of the outstanding stock of government securities on foreign institutional investors announced on March 27, 2019 by the Reserve Bank of India (RBI) should be revised upwards to at least 10 percent to match other emerging markets.
Medium Difficulty: RBI Notification — Internal opposition due to traditional bias against foreign borrowing for consumption expenditure, and/or investments, as well as repayment fears arising out of currency exchange risks.
This is the ninth installment in a new series of articles on the India Reforms Scorecard: 2019-2024 by the staff and experts at the Wadhwani Chair in U.S.-India Policy Studies. The series seeks to provide analysis on why reforms marked as “Incomplete” or “In Progress” have not been completed, and the impact such reforms can have on specific sectors or the economy at large.
Foreign portfolio investors — comprising both foreign institutional investors as well as qualified foreign investors — are an important component of bridging the savings and investment gap in a high growth developing economy like India. Despite the recent slowdown, India’s investment needs are growing and investment financing will need to be supplemented by external sources for the foreseeable future.
One of the main concerns around limiting foreign portfolio investment (FPI) in debt securities has been to ensure that overall external commercial debt levels are manageable. FPI investments in Indian rupee securities create a foreign currency repayment obligation as foreign portfolio investors are guaranteed the right to convert and transfer the principal and interest proceeds of their local currency debt investments in foreign currency. This consideration is apparently a principal driver of the careful and conservative pace of opening domestic debt securities for investment by foreign portfolio investors along with the traditional bias against borrowing from external sources to fund consumption expenditures or investments that do not generate foreign exchange earnings directly or indirectly.
India has a long and successful track record of attracting foreign direct investment (FDI) and continues to be one of the most attractive destinations for FDI around the world receiving over $62 billion in FDI in 2018 alone. Although FPI was permitted much later, starting with investment in public equities in the 1980s, and followed by FPI in other financial instruments; it has become a major contributor of investment capital to India’s economy both in the public and private sectors.
India needs to weigh its traditional aversion to foreign investment risks against the changed economic realities of India where the country’s ability to service external debt is stronger than ever before with foreign exchange reserves being around $455 billion and in a position to cover 11 months of imports in December 2019.
Supplementing domestic resources with foreign capital is extremely important as the economy is in dire need of stimulus. One of the best ways to supplement government fiscal is the issuance of a greater volume of longer-term securities in local currency to foreign portfolio investors. Such issuance does not create currency risk which is taken by the foreign investor.
A key positive outcome is the continued buildup of investor confidence in the medium to long term macroeconomic stability of the Indian economy which would enable Indian issuers to issue longer dated local currency debt in international markets and diversify their funding sources. This is particularly relevant in the current context of reduced credit availability.
This is also an opportune time to increase foreign portfolio investor participation in government securities. Institutional investors, globally, are facing a persistent low yield environment and are looking for fixed income investment alternatives that can offer a higher return than available in traditional fixed income asset classes. They are likely to accept lower yields on Indian government securities which will exert downward pressure on the yields overall in the domestic market. Issuance of more government securities as opposed to corporate paper to foreign portfolio investors, will also deliver a stronger market signal as such issuance would attract a greater volume of interest amongst such investors due to risk, liquidity, and issue size considerations.
Even if the government is not planning the issuance of new securities increasing the participants of foreign portfolio investors in the existing stock of government securities will help achieve these impacts of building greater confidence and reducing yields in the secondary market which support successful new issuances in the future at lower costs.
The government can signal to the global investor community that India is now a major fixed income market deserving of larger allocations in global investment portfolios by increasing the ceiling on FPI in government bonds. Such an increase would allow a meaningful increase in the investment opportunity for international investors without creating unmanageable risks as it would add only $35 to 40 billion to the foreign debt, from the current level of approximately $557 billion. The tradeoffs are clear; there are low downsides and significant upsides to increased FPI participation in the Indian government securities market.
Mr. Arun Kumar Sharma is a Senior Associate (Non-resident) with the Wadhwani Chair in U.S.-India Policy Studies at CSIS and president of Grovepike Associates, a global strategic and financial advisory firm based in Washington D.C.