Until now, all eyes have been on FII investment fluctuations in the equity market. However, as we watch the consequences of the massive pull-out of FII investment from the debt market play out, it emerges as a new source of volatility for the Indian rupee
In June 2013 foreign institutional investors (FII) pulled out Rs22,000 crore from the debt market. This is a staggering amount, because as much as 12% of total FII investment in the Indian debt market flew out in a span of 21 days. To put things in perspective, the second largest FII outflow from the debt market was less than Rs8,000 crore in March, 2012 and the largest outflow from the equity market where much more foreign money has come in, was about Rs17,000 crore (7.2% of total FII investment) in January 2008.
This came at a time when the current account deficit (CAD) was already precarious, having reached an all-time high of 6.7% of GDP at the end of 2012. India’s trade deficit too reached a seven-month high in May at $20.14 billion because of an almost 90% annual increase in gold and silver imports. These factors have together, compounded and exacerbated the volatility of the Indian rupee. However, FII investment and exit from the debt market has now emerged as one of the main factors that will determine the value of rupee, a value that will be set through a path of far greater volatility.
It is interesting to note that the equity market in comparison, has witnessed a drop in FII investment only of a little less than Rs2000 crore, less than 1% of total investment. This is a very small figure as compared to January 2008 and October 2008 which both saw pull outs of over 7%. Large pull outs from equity markets often tend to be self-limiting. If a significant amount of capital was to flow out of an equity market, equity prices would drop considerably. Buyers would then step in to take advantage of lower prices, thus mitigating the impact of a mass-selling. However, this has not happened in the bond markets, possibly because bond prices still remain high.
While foreign flows into the equity market have always been a determinant of the strength of the rupee, the phenomenal growth of FII in debt over the last few years has created a new source of vulnerability for the rupee. FII inflows and outflows are often exogenously determined factors that the Indian government can have little control over, such as the tapering of quantitative easing (QE) by the US Federal Reserve.
When the rupee falls, foreign investors stand to lose from their Indian holdings, leading to a possible pullout from the market. A volatile currency also means that foreign investors need to pay more to hedge against a rising foreign exchange risk. Although yields from Indian debt are higher than other emerging markets like Brazil, Mexico and Hungary, these relatively high returns do not appear to be attractive enough against a falling rupee.
Two other factors have contributed to this massive pullout. The anticipated tapering of quantitative easing by the US Fed is likely to severely limit the liquidity at the disposal of FIIs to invest in emerging bond markets. The increase of treasury yields in the US, with the difference between yields in the 10-year US Treasury and the 10-year Indian G-Sec falling to 5.09% from 5.46%, also encourages a rebalancing of FII portfolios towards developed markets.
India’s immensely high current account deficit of about 6.7% of GDP increases the rupee’s sensitivity to disturbances in the external sector. One of the reasons that India managed to come out of the 1997 currency crisis relatively unscathed was that the CAD was low, at just about 1.25% of GDP in 1996-97.
After falling 1.5% against the dollar in response to massive pull-outs from the debt market, the rupee strengthened slightly on 21st June, closing at Rs59.26 against the dollar, up from Rs59.58 on 20th June. Inflows into the debt market, bolstered by Essar Steel’s 1 billion dollar fund-raising programme helped the rupee recoup to a small extent.
However, on Monday, the rupee weakened again. These fluctuations are indicative of just how vulnerable the rupee is under current circumstances. Volatility will only increase as the debt market grows and huge amounts of money move in and out. This increasing volatility is likely to have a seriously adverse impact on manufacturers of exports and investor confidence. The bridging of the current account deficit is also likely to become increasingly difficult.