Gilts: foreign holding to go up slowly

In last Tuesday’s post-policy press conference, Reserve Bank of India Governor Raghuram Rajan backed proposals to allow greater foreign participation in the government bond market. Specifically, there are suggestions that the limit on foreign investors would be reset in rupee terms, instead of US dollar. We expect that the authorities might wait for clarity on US Fed normalisation before taking a final call.

While the indication that foreign investors’ debt quota may be raised is positive for gilts, other related factors, such as growth and inflation dynamics, USD interest rates, the government’s fiscal position and changes to the statutory liquidity ratio (SLR) also weigh heavily. We suspect that the full benefits of liberalisation are likely to materialise only over the longer term.

Marginal impact

Foreign ownership in gilts is heavily restricted and foreign portfolio investors (FPIs) are allowed to hold only $30 billion in gilts (less than 5 per cent of total outstanding gilts). Recently, there have been indications that the FPI debt quota may be denominated in rupees rather than in US dollars; the FPI limit may rise by more than 20 per cent with this. And foreign investors would be able to purchase roughly $6 billion more gilts — one percentage point.

The amount of total outstanding government bonds held by foreigners in India, at less than 5 per cent of gilts, is one of the lowest in the region. The ratios are larger in Indonesia and Malaysia at more than 35 per cent, and over 10 per cent for Korea and Thailand. But FPI quota may only expand at a slow pace as India seeks to avoid over-reliance on foreign funding. One of the key reasons behind the hesitance to open the domestic bond market is the sizeable scale of government borrowings. This, in turn, has its roots in the economy’s persistent fiscal deficits.

In a bid to ring-fence borrowing costs from external volatility over 90 per cent of the market borrowings are presently held domestically, which have helped keep yields fairly stable.

Liberalisation of FPI ownership is likely to be contingent on continued fiscal consolidation and external developments. In recent years, India’s fiscal position has been on the mend. Budget consolidation has been on track, with the government expected to narrow the FY15/16 deficit to -3.9 per cent of GDP after faring better than last year’s target. And this year, revenue (barring divestment) and expenditure targets are also relatively realistic, with the April-May 2015 deficit trailing close to the goalpost.

Yield outlook

The process of easing is, however, likely to be gradual. Over time there could be spread compression of IN Gilt yields over UST yields of similar tenors.

We maintain that gilt yields are biased steady to modestly higher over the coming four quarters. Alongside the domestic inflation dynamics, an expected rise in UST yields as Fed normalisation takes place should put a floor to the IN rates. Two-year and 10-year gilt yields are expected to hold around 7.8 per cent in the coming months before heading towards 8 per cent by the end of the year.

Moreover, there are no clear indications that the RBI is ready to embark on an easing cycle. Comfort is being drawn from lower commodity prices and improved monsoon outlook (until end-July), but external developments will also have an important bearing on the policy direction. We retain our on-hold rate call until end-2015 while watching sequential inflation trends closely.

The writers are economists at DBS Bank