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Indian government and RBI played the card of highlighting double-digit dollar returns to investors, who could leverage. While this may buy them some more time markets will, eventually, judge fundamentals and not jugglery
Last few months, every time the Indian rupee is discussed, focus on current account deficit (CAD) is inevitable. CAD has been analysed threadbare and debated ad-nauseam, with oil and gold imports hogging the limelight.
But while we tried to fund the CAD, have we compromised on our ability to keep attracting long term funds at reasonable cost? Would it be problematic to even fund lower absolute CAD levels going ahead?
The following is an attempt to analyse the major sources of capital flows with some numbers and trends. We will start with what are relatively smaller inflows and move onto the bigger ones.
Table below has various NRI account categories with flows for respective categories in adjacent columns.
The NRO rupee denominated accounts for NRIs started in 2006 and promised returns similar to domestic deposit rates for NRIs, who had some rupee transactions to use such accounts. But the NRI, who would probably be looking for dollar returns, was essentially taking the currency risk.
FCNR (B) deposits, which are dollar deposits, were essentially stagnant probably because the returns were not good enough.
As CAD grew post-2008, NRO proved to be inadequate in terms of providing its share of capital flows. RBI deregulated the interest rates offered on NR(E)RA, which are also rupee accounts for NRIs wanting to park funds here. Rupee returns, comparable to domestic interest rates, meant money flooded the country in post-deregulation in 2011.
Funds invested in NR(E)RA were accounts were freely repatriable, unlike NRO accounts, where there were restrictions imposed. But as with NRO, here too, currency risk is taken by the investor.
But take a closer look at the flows and outstanding amount changes in 2013 and 2012 for the NR(E)RA and NRO accounts. These flows also include the accrued interest. The change in the outstanding dollar amount in these accounts is lesser than what the flows would suggest.
For example: In the NR(E)RA accounts while the flows suggest about $25 billion inflow in these two years, outstanding balances changed by around $20 billion only. This $5 billion is the hit NRIs would have taken on their accounts due to rupee depreciation in the same time frame. So while they expected to make maybe 9% rupee returns on the deposits, currency ate away a big part of the return. And this was as of March 2013, what happened in May-July 2013 could have caused further damage, almost to the extent of wiping out all returns and threatening a dent in the principal amount. Story for NRO accounts would be similar.
Next we come to commercial borrowings
Here we discuss both external commercial borrowings (ECBs) by corporates and investments by FIIs in the Indian debt market.
As far as ECBs are concerned, all corporates who thought there was a free lunch on offer in form of cheap unhedged dollar loans, had to foot a huge bill for their meal. Whether this deters them from further dollar borrowing and whether hedged dollar borrowing saves enough money to be worth the effort of taking it are questions which will decide size of incremental dollar borrowing. But to say the least, it has not been a happy experience for quite a few of them.
Short term credit seems to be taking larger share of the borrowings, as commercial borrowings seem to be settling at low levels, essentially reflecting the concern on currency movements.
As CAD went berserk, RBI and the government opened up the debt markets for the FIIs, trying to attract dollars to a market which was almost shut for FIIs. The limits for investing went up with each passing quarter and now around $50 billion is the cap on the FII investments in the debt market across categories.
FII investment went ballistic from about $5 bn in March 2009 to around $38 billion in May 2013. But once arbitrage became incrementally non-remunerative, money started to flow out. And FIIs have withdrawn $10 billion since then. NSDL website shows the rupee value of FII investments to be around 1.45 lakh crore. This corresponds to around $23-24 billion, when it should have been $28 billion (38 minus10=28). The gap is, of course, there because the rupee depreciated and again it’s the investors who took the hit of around $4-5 billion.
Then we come to FDI
While FDI going abroad is an important factor, we are just considering the incoming FDI and its effects here. The aim is to discuss the sustainability of the inflows of FDI to India.
The reported FDI has come down from $35 billion levels to around $27 billon levels. That is in the face of Indian economy almost having doubled in dollar terms. But even that may not give the complete picture.
“Reinvested Earnings”, which is essentially retained earnings from existing FDI investments on the ground in India, is creeping up as a % of the total incoming FDI reported. Average reinvested earnings of around $8 billion per annum have now gone up to around $10 billion. This has been so, while fresh FDI equity inflows have slowed down from mid-20s to teens.
With an existing base of around $230 billion FDI in the country, $10 billion would roughly correspond to 4-5% reinvestment. In the course of normal businesses that reinvestment number seems par for the course and doesn’t necessarily give an idea of incremental attractiveness for FDI investment into India.
But “fresh” FDI equity, which may probably reflect the same, has slowed down. Reasons for this are well known. Effectively without dramatic changes in the situation on the ground, FDI may continue to stagnate.
“Primary Income”, in the table above, reflects the earnings for the foreign investor from all forms of investments, whether stocks/debt or FDI. As external debt and existing base of FDI keeps going up, there is a very good chance the “Primary Income” number will slowly creep up and resulting outflows will become bigger. Last year it came close to equalling the reported incoming FDI itself.
And let us not forget, FDI investors also get hit because of rupee depreciation. So if it has gone from 40 to 60 to the USD, FDI investors who had come in at lower currency levels in 2007 or 2008 have suffered to the same extent.
Finally the biggest of them all, FIIs in equity
Nifty is where it was 6 years back. Currency has depreciated by around 50% in the same time frame. Indices reflect only the top companies, the less said about the broader markets, the better. And this performance is in spite of the billions of dollars that FIIs have poured in every year.
While FIIs may have made some money in specific stocks, broader markets have been disappointing to say the least. They have not performed in Rupee terms, forget dollar terms.
That they still keep coming in hope of better times is an enigma in itself. How long will they keep coming in despite the hammering that currency is giving them, is a big question? Or is there infinite patience out there?
Whether it is NRIs, FII/FDI investors or ECB borrowers, all those who, knowingly or unknowingly, helped bridge the CAD, directly or indirectly, have taken big knocks on their bets and balance sheets. If the situation continues to stagnate, it becomes difficult to attract them incrementally.
One can possibly argue that hedging would have saved them the losses. That’s right but somebody else would have to take the hit. There are no free lunches right? And as more people think its better to hedge, forward premiums on Rupee have shot up. Essentially that’s the markets way of choking loss-making investments or “capital misallocation”, if you like.
It is in that context that the latest move from RBI on the FCNR (B) deposits needs to be seen. Since returns on equity/debt, which have been underperforming, cannot be guaranteed and FDI, kind of, dries up, government and RBI played the card of offering mouth-watering double-digit dollar returns to investors who could leverage. While this may buy them some more time, markets will eventually judge fundamentals and not jugglery.
The already tight rubber-band just got stretched even further. Hopefully we will get our act together before it snaps.