Accountable to the world

Shakiness after the outflow from the Indian debt market shows how much power global investors have over the local economy

The whole emerging market (EM) asset class has been hit in the past few weeks. EM currencies, stocks and bonds have faced the heat, even as investors have begun to recalibrate their expectations of the US Federal Reserve's policy. Will the Fed taper its $85-billion monthly bond buying programme, by how much and when? These questions are uppermost in many investors' minds.

EM economies have been huge beneficiaries of the nearly $12 trillion of extra liquidity pumped into financial markets by central banks since the global financial crisis. Given how extended investor positioning was - in a frantic search for extra yield irrespective of risks - it is not surprising that at the first signs of a reduction in liquidity, the EM asset class has gone into a funk.

Rising yields on 10-year US Treasury bills (now about 2.2 per cent) are another manifestation of changed investor perceptions. For the first time in more than 18 months, real yields on the 10-year bond have turned positive, after being negative 75 basis points as recently as April. The search for higher yields in the EM world is now being reversed. This reversal has also been forced by the liquidation of the yen carry trade, as buying risky assets funded by yen borrowings will not work if the yen stops depreciating and either appreciates or turns volatile.

The South African rand and Brazilian real both hit a four-year low against the dollar. The rupee sank to a new low, close to 59 against the dollar. The FTSE emerging markets index is down about 10 per cent from its May peak, and certain markets such as Brazil are now down nearly 20 per cent. Most EM bonds have declined, leading to a rise in yields. And in many bonds, liquidity has totally disappeared. International bond funds have suffered their biggest redemptions since mid-2007, and EM equity funds have faced their biggest outflows since 2011. While the EM asset class will eventually settle down, as the end of quantitative easing does not look imminent, this correction has shaken off many of the weak holders.

As for India, this mini sell-off has exposed just how vulnerable the country is to foreign flows and its need for a continued risk-on environment. It seems that $3.5-3.7 billion of foreign institutional investor (FII) outflows from our fixed-income markets has been enough to totally change the mood on the rupee and undermine confidence. Once confidence is broken, the normal leads and lags of exporter/importer behaviour - exporters wait to bring in their remittances and importers rush for cover - accelerate the rupee's downward spiral. India shows up on any macro screen with its huge current account deficit, and the rupee is being actively shorted by macro funds.

Flows into our fixed-income markets picked up once the government reduced withholding taxes to five per cent, and also raised the quantitative limits on FII ownership of Indian fixed-income paper (both gilts and corporate bonds). Yields on India's 10-year government securities moved down from near eight per cent to 7.2 per cent, before reversing back to 7.35 per cent now, as FIIs have sold about $3.7 billion worth of bonds since May 22. One should expect these outflows on the fixed-income side to continue since, at current yields and on a fully hedged basis, there is very little yield differential between Indian government securities and US Treasury bills (yields on Treasury bills have risen and the cost of hedging rupee exposure has risen sharply). With a very limited yield pick-up, why would any FII invest in Indian debt? Existing investors in debt, who have been spooked by the currency moves, are also bailing. For any FII to invest in Indian debt today, they must be willing to take a currency call,- not something many debt investors will do willingly.

Surprisingly, we have not seen any significant outflows on the equity side, while FIIs continue to show great faith in the India story. Over the last 18 months, FIIs have pumped in nearly $45 billion into Indian stocks. These inflows are disproportionate to the rest of the region, and must be questioned for sustainability. The government has gone out of its way to point out that current FII outflows have only been from debt markets and not equities. While being trumpeted as a strength, one wonders whether this is an additional vulnerability. Surely India cannot swim against the tide forever. We will almost certainly see equity outflows at some stage if the EM turmoil sustains. Redemptions will hit everyone. What will happen to our markets, both foreign exchange and equity, if we suddenly see $5 billion of equity outflows? We have to get our macro fundamentals in place, otherwise I don't see how an economy growing at only five per cent with a currency that has depreciated by almost 35 per cent since the end of 2007 can continue to interest equity investors and attract flows of the magnitude needed to fund our current account.

International investors have been extraordinarily kind to India, and consistently given it the benefit of the doubt. We have benefited by being seen the least bad in a tough neighbourhood. China, Brazil, Russia, Korea, Turkey, South Africa and Taiwan (the other major EM markets) have their own unique issues. This lack of alternatives provides our policy makers a window to put in place the structural changes needed to get our own growth story back on track. We have to use this time wisely - for one can already sense investor fatigue once again setting in towards India, as the finance minister's promises do not seem to be getting translated into policy on the ground.

FIIs own about $35 billion of Indian debt. If an outflow of about $3.7 billion can cause so much damage to investor psychology and market confidence, it shows that we are, for the first time, fully accountable to debt markets and global investors. While the current outflows are owing to global turmoil, any policy measure that is seen as negative and anti-growth can now be met with large-scale selling - thereby disrupting yields, exchange rates and market psychology. For the first time, Indian policy makers will have to deal with independent bond market participants big enough to cause market disruptions, and as a country will have to be subject to the same economic checks and balances and global influences as other developed countries.

There's no such thing as a free lunch: if we want global debt flows, we should be willing to be subject to their disciplinary forces. We have never had to be more attuned to global investors' perceptions of India than today. I would argue that the whole reform burst on the foreign direct investment front and on reining in the fiscal deficit was driven by the compulsions to avoid a ratings downgrade. Global investors have never had more power over our markets - which is not necessarily a bad thing, since they will act as a check on policy formulation.

Our need to fund a large current account deficit has forced us to open up our financial markets. As a consequence, we need to subject ourselves to the discipline of market forces and handle the volatility of global flows and market psychology. I am not sure our political establishment is prepared for, or even aware of, this new-found market discipline and accountability.
The writer is fund manager and CEO of Amansa Capital