Is Indian Debt Market closer to Global Bond Index Inclusion?

All markets have been fearing the impact of likely US Taper, likely announcement to happen over this week with cut backs to start as early as January.  Interestingly, Indian bond markets have seen sharp inflows in the last one week, despite the slew of good economic data in US. Tbills and dated securities have been bought by FIIs to the extent of INR 2000 Cr each, intense buying post the CPI data. 

Most of the dated securities buying has been by the Longer term investors (like Sovereign wealth funds, Pension funds, Insurance funds etc.). Buying of Tbill at the current USDINR forward levels suggest the FIIs' comfort on USDINR spot as well - as they can't be hedging when the forward levels are so high (8.25%+LIBOR).

Are we closer to bond index inclusion than what the local markets believe?

Source of Data: NSDL

INR – Target 60-61/$ - Next 3 Months

Factors behind the Current INR Downmove:

Outflows: The major weakness in INR began in the second half of May where significant outflows happened from Debt aggregating close to $9 Bn and Equity outflow of close to $1 Bn. 

CAD Concerns: Spike in Gold Imports on the back of Govt. action on increasing duties. Though expected to be front loading of the year’s gold demand, the resulting imbalance along with the Capital outflows exacerbated and quickened the down-move.

Debt Repayments: As a consequence of the negative sentiment on the currency along with QE Tapering Concerns, INR along with most EM peers faced severe depreciation pressures raising concerns about ability to raise fresh funds overseas and hence repaying capacity of existing debts.

External Debt Profile

• India’s external debt, as at end-March 2013, was placed at US$ 390.0 billion showing an increase of US$ 44.6 billion or 12.9 per cent over the level at end-March 2012.
• The share of short-term debt in total debt, by original maturity, was 24.8 per cent. Based on residual maturity, short-term debt accounted for 44.2 per cent of the total external debt as at end-March 2013. Of this, the share of NRI deposits was 28.4 per cent.
• The residual maturity profile and comparable countries’ debt profiles are as per the following tables:

Residual Maturity	< 1Y	1Y to2Y	2Y to 3Y	> 3Years	Total
Total External Debt ($Bn)	172	33	34	151	390
Corporate Debt ($Bn)	110	20	24	80	234
Sovereign Debt ($Bn)	13	6	6	60	85
NRI Deposits ($Bn)	49	7	4	11	71

CAD as % of GDP	2013	2012	2011
India	-5.10%	-4.65%	-2.99%
Brazil	-3.01%	-2.01%	-2.21%
Russia	2.98%	5.62%	4.21%
South Africa	-5.80%	-5.00%	-2.60%
Thailand	0.10%	0.66%	3.07%
Indonesia	-3.08%	-0.54%	0.82%
Malaysia	5.19%	10.44%	10.15%

Emerging Market Currency Performance:

The following table lists the relative performance of various EM currencies; INR’s performance is comparable to IDR and BRL though better than ZAR – mainly reflective of the higher CAD. With CAD% likely to go down this year to -3.7%:

Currency	1M%	3M%	6M%	YTD%
INR	-5.67%	-12.26%	-14.96%	-13.19%
BRL	-5.74%	-12.98%	-15.62%	-12.66%
RUB	-2.03%	-4.89%	-7.78%	-7.51%
ZAR	-5.48%	-6.98%	-13.47%	-17.28%
THB	-2.80%	-6.08%	-6.33%	-3.94%
IDR	-7.76%	-11.53%	-12.25%	-11.44%
MYR	-3.70%	-8.11%	-6.14%	-7.35%

Recent Movement in Foreign Currency Reserves

The Foreign currency reserves of the country have trended lower in the last 6 months – an indicator of the central bank intervention in the FX market.  With 44% of total external debt being short term, further erosion of FX reserves can be a major risk factor looking ahead. Hence, the capital raising efforts of the Government (the recent measures) would turn out to be “necessary” sooner than later.

Recent Measures announced to support INR

Following are the key measures announced by the Finance Minister in the last 2 weeks

• Easier overseas borrowing norms, especially for oil companies ($6 Bn): Two changes done in this regard – one, oil companies are allowed to raise $4 Bn to meet working capital requirements; two, subsidies of MNCs are allowed to raise debt from parent companies – expected to raise $2 Bn
• Liberalization of the non-resident India (NRI) deposit scheme ($1 Bn)
• Issuance of quasi-sovereign bonds ($4 Bn): Three public-sector financial institutions are expected to raise $4Bn by issuing quasi-sovereign bonds. Sovereign wealth funds can invest up to 30% in the INR 480bn of tax-free bonds to be issued by public-sector financial institutions. If fully utilised this could provide another $2 Bn of additional inflows in the remainder of FY14.
• Import duty hikes: Gold and Silver import duties have been hiked to 10% from 8% and 6% respectively; going by recent record, this is not likely to provide immediate impact.

Expected Outcome

Measures	FX	Rates	Credit Growth
RBI Intervention: continuation of periodic central bank action	Positive: Direct impact. Medium term impact is bad owing to erosion of reserves	Negative: as liquidity is expected to become tighter	Neutral
Continuation of Tight Liquidity Conditions	Neutral: Positive flows in debt likely to be offset by negative flows from equity	Negative: Direct impact.	Negative: NPA concerns to rise
External Fund Raising (incl quasi sovereign, NRI Depo & ECBs)	Positive: Ease funding concerns and positive capital flows	Positive: Can potentially lead to early relaxation of tight liquidity measures	Positive: Similar to Rates impact, headwinds are reduced

If the planned inflow of $11 Bn does happen, a 50% retracement of the last 6M move can be expected – with INR trading close to 60-61/$. Current 3M Outright Forward is ~ 65.50/$ : Target of 61/$ corresponds to a 7% absolute return objective.

RBI: Money market rates and Rupee Defence

Having the benefit of a late response: RBI followed up the Jul 15 measure with further tightening this week: restricting the LAF borrowing by banks to 0.5% of the banks' individual NDTL - this does two things:

(1) Restrict overall LAF borrowing max at 35k Crs
(2) Making funding of excess SLR by banks and Primary dealers expensive and/or uncertain.

The excess SLR holding of banks is close to INR 4 lac Crores and that entire portfolio's funding cost can now swing between 7.25-10.25 which effectively means banks with excess SLR will not venture into adding to their portfolios at this point: good illustration is yesterday's and today's Tbill cutoffs of >11%, last week's devolvement og G-Sec auctionand likely devolvement this week as well. The yield curve could remain inverted till the measures are reversed and markets clearly perceive that inflation & currency risks are addressed and that the focus of RBI will shift towards growth. With the impact of the fresh reporting fortnight kicking in from next week, the movement in overnight rates could be interesting - one solace would the Govt's month end spending.

To see the impact of the RBI measures to FX market: the Forward premia and MIFOR levels have shot up in line with other rates curves effectively making it prohibitively expensive for anyone to buy forward dollars. This means different things for different players:
(1) If FII flows do come into debt, these would have to be unhedged by the sheer unattractiveness of the hedge - meaning RBI is directly signaling the long term players amidst FIIs like Pension funds, Sovereign wealth funds are welcome and not the arbitrageurs (aka hot money) playing the interest rate differentials.
(2) With an explicit support to INR spot, exporters still can forward sell their dollars at almost the same levels as in the 2nd/3rd weeks of July (despite the 90p downmove since Jul 15). This effectively encourages exporters to hedge and importers not to hedge.

From behavioural front, the sheer pain of most banks in their bond books would make them speculate much less in FX. After all, quarterly results and NIMs matter. 

Going forward, I would be keenly tracking how much redemption pressures come to Debt mutual funds. If that turns out to be material, along with the relentless supply till end August and queasy funding costs, yields can head higher even from these levels - we are already in uncharted zone in this currency cycle. On my personal HTM portfolio, I would put more money in debt funds than in equity funds at this point.

At the risk of being an hyperbole, money markets have got a step-motherly treatment to bring some stability to the favoured FX spot. All said and done, INR Spot will remain the cynosure of the central bank in the near term