Short-term by nature

The Reserve Bank of India’s move, in its recent monetary policy, to limit foreign institutional investor (FII) investment in debt to only dated securities with a maturity of one year and above is well-intentioned. From June to August last year, FIIs cumulatively pulled $9.25 billion out of India’s debt markets, a major factor behind the rupee’s crash to the all-time-low of 68.8 to a dollar. The RBI has every reason, therefore, to be worried about a fresh currency volatility triggered by FII selling, particularly in short-term debt instruments. The risk of sudden withdrawal of ‘hot money’ cannot be underestimated in the event of a reversal of global investor sentiment, whether arising from the US Federal Reserve deciding to hike policy rates or any unanticipated geo-political event.

Where the above reasoning is faulty, however, is in assuming that curbs on short-term debt inflows will automatically encourage longer-term investments from FIIs. FII money, by its very nature, is fickle in relation to more stable foreign direct investment. FIIs largely play for quick gains; trying to convert them to long-term investors is futile beyond a point. Imposing unnecessary controls will only make this money move to other competing destinations for global investor funds. In the case of debt, FIIs prefer securities maturing before a year since trading volumes are highest in this segment, making it easier to find counterparties to deals. It is not surprising to see the RBI’s action to curb FII investments in short-term debt, which is already causing turbulence in fixed income markets. In the past five days alone, FIIs have shed over $600 million in debt investments. Yields on the government’s benchmark 10-year bonds have also spiked above 9 per cent, which may have partially to do with resultant reduction in demand for debt.

The fact that FII investment in debt is essentially short-term can also be seen from the profile of investors. Within FIIs, there are those with somewhat longer investment horizons: sovereign wealth funds, insurance and pension funds, multilateral agencies and foreign central banks. But these investors are currently holding just ₹10,000 crore of government debt, whereas the corresponding holdings by ‘riskier’ category investors — foreign individuals, companies, mutual funds and hedge funds — are in the region of ₹75,000 crore. Nor would restricting FIIs from short-term debt stop them from speculating in long-term securities. What stops FIIs, after all, from buying and selling even bonds maturing after one year in the secondary market, so as to trade on currency volatility or interest rate differences? Even long-term investors may not hesitate to sell and exit when confronted with the possibility of erosion in profits or if they get a better investment opportunity in another country. It would be best to accept FII investments for what they are: short-term and fickle.

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