The long-term investment case for Indian government bonds has never looked better. A credible inflation targeting framework, disinflation, high real yields, low currency volatility and bonds being under owned by foreign investors are key elements of the investment backdrop.
Currently, foreign portfolio investor (FPI) investment in government bonds is about 3.8 per cent of the total. In a post media interaction the central bank indicated a medium-term framework for the FPI limit is being worked upon. Elements of the framework would include - the percentage of the sovereign bonds made available for FPI's; limits that do not vary with exchange rate movements and participation by different categories of FPI's.
If one looks at comparable countries in the region such as Indonesia, foreign investors own about 40 per cent of Indonesian bonds. Foreign investors began investing in Indonesian bonds in 2003. Even during the global financial crisis, outflows were about $5 billion and more recently during the taper tantrum they were about $3 billion. The point being made is that India should not be extremely concerned with bond outflows, especially when our fundamentals are improving on a sustained basis. In Malaysia and Thailand, foreign ownership of sovereign bonds are about 30 per cent and 15 per cent of those outstanding.
Then, the question is: What is an appropriate FPI limit for India? The emergence of solid, sustainable fundamentals - fiscal consolidation towards three per cent over the medium term, a current account deficit of below two per cent and anchoring of inflation to four per cent by 2018 suggests there is merit in thinking about a target of a 10 per cent limit of bonds for FPI's over the medium term. This would amount to $65 billion of flows that could be sequenced over three years, taking into account global monetary policy settings and contextual liquidity conditions in the banking sector. There is merit in opening limits, as the US Fed gets underway. This would be viewed by FPI's positively, as it would be undertaken from a position of strength given the steady and sustainable improving fundamentals.
Over a period of time as India soft lands on a thhree per cent fiscal deficit and CPI, limits for FPI's should be completely free even as the statutory liquidity ratio (SLR) requirements for banks are dispensed. This will set the stage for India's inclusion in global bond indices. Even assuming assets of around $200 billion tracking one of the indices, a 10 per cent weight could see inflows of $20 billion that would grow over time. Policy could also be calibrated such that categorisations such as 'hold-to-maturity' that inhibit bond market liquidity be done away with. These measures would help foster the growth of a deep and liquid sovereign bond market - essential to finance supply side economic policy.
To sum up, a lot of disinflation that has occurred has happened without yet firmly anchoring inflation expectations (IE). By their very nature IE are adaptive, if inflation targeting successfully delivers CPI at four per cent and lower by 2018, then surely IE, too, would adapt much lower bringing more bang for the buck to the disinflation process. Small wonder then that 10 year sovereign bond yields at eight per cent is a compelling investment opportunity for the unlevered medium-term FPI.
The author is head of fixed income and currencies, Deutsche Bank India. Views are personal.
