## Thursday, April 23, 2020

### Liberalising foreign capital flows in Government debt: No time for incrementalism

On March 30, 2020, the Reserve Bank of India announced a "Fully Accessible Route" (FAR) that gives unlimited access to foreign portfolio investors (FPIs) to a select set of government securities (G-Secs), specified by the RBI from time to time. To the extent this initiative facilitates the liberalisation of India's capital account and aids market development, it is a step in the right direction. Opening up a set of G-Secs to unrestricted foreign investment may contribute to the depth and diversity of the market and also impose greater discipline on fiscal policy. However, it may only be partially effective unless accompanied by structural reforms and simplification of existing rules governing the access of FPIs to G-secs. In this context, we highlight three fundamental issues with the framework determining foreign investment in G-Secs: (i) frequent changes in rules resulting in uncertainty, (ii) fragmented landscape leading to complexities and (iii) a missing economic rationale for what appears to be an over-prescriptive regime.

The policy initiative announced by the RBI has been taken in furtherance of the budget statement made by the Finance Minister prior to the outbreak of the Covid-19 pandemic. However, the timing of the RBI's announcement is apt. There is a reasonable probability that in the coming one or two years, as a consequence of the ongoing economic crisis that has been triggered by the pandemic, domestic investment and savings will undergo large changes. As a result, India's current account deficit (CAD) may increase significantly. A large amount of foreign capital will be required to finance the rise in CAD. In that context, the FAR initiative is a timely policy decision. It is envisaged that the removal of caps on FPI investment in G-secs may allow India to be included in the global bond indices. This would pave the way for higher and stable foreign capital inflows.

Until recently, foreign portfolio investment in G-Secs was capped at 6% of the outstanding stock of such securities. In addition to the overall cap, investment by FPIs in short-term G-secs was capped at 30% of the overall investment of a particular FPI. According to the FAR scheme, FPI investment in specified G-Secs would not be subject to the 6% cap.

With the introduction of FAR, G-secs can now be classified into two categories:

• Those in which FPIs are allowed to invest without any limit.
• Those in which FPI investment will be capped at 6% of the outstanding stock of these securities.

As of March 30, the RBI has specified the following G-secs as eligible for the FAR:

1. Five specific outstanding securities, which have already been issued by the government. These securities have a residual maturity of 5, 10 and 30 years respectively.
2. All G-secs of 5-year, 10-year and 30-year tenor which will be issued by the government in the financial year 2020-21 as part of its annual borrowing calendar.

The G-secs of the kind referred to in item (1) together account for a market capitalisation of Rs 4.4 lakh crore which is less than 4% of the total government debt (Table 1). However, the securities referred to in item (2) will constitute roughly 63% of the half-yearly borrowings (Rs 4.88 lakh crore) of the Union Government under the annual borrowing calendar for 2020-21. Hence, this could potentially amount to a sizeable liberalisation.

 ISIN Nomenclature Date of issue Date of maturity Outstanding stock (Rs. Crore) IN0020190396 6.18% GS 2024 4-Nov-2019 4-Nov-2024 48,552.52 IN0020180488 7.32% GS 2024 28-Jan-2019 28-Jan-2024 87,000.00 IN0020190362 6.45% GS 2029 7-Oct-2019 7-Oct-2029 1,05,840.16 IN0020180454 7.26% GS 2029 14-Jan-2019 14-Jan-2029 1,18,830.80 IN0020190032 7.72% GS 2049 15-Apr-2019 15-Jun-2049 84,000.00 Total 4,44,223.48 Source: Reserve Bank of India

## Frequent changes in the rules of access

India has always had a complex system of capital controls which are relaxed from time to time in a discretionary and piecemeal manner (Patnaik et al.,2013). Controls are relaxed or tightened on a continual basis, depending on the needs and exigencies of the economy. From 2014 till date, there have been several flip-flops by the authorities, on the rules of FPIs' access to the G-sec market. Table 2 gives an overview of the key changes in these rules from 2014 until 2019. The third column indicates whether the intervention relaxes or tightens the rules of access, relative to the prevailing legal position.

 Year Event Restriction or liberalisation Upto July 2014 FPIs could invest in the G-sec market subject to an aggregate cap of USD 30 billion. Sub-limits were assigned for investment by FPIs in G-secs of shorter tenors such as Treasury bills and longer term G-secs. -- February 2015 RBI prohibited FPIs from investing in: (a) G-secs with a maturity period of less than three years, and (b) liquid and money market market mutual funds. Tightening October 2015 RBI announced a medium term framework within which: (a) the absolute cap on aggregate FPI investment would be announced in INR; (b) the cap on FPI investment in G-secs would be increased annually such that it reaches 5% of the outstanding G-secs by March 2018; (c) the aggregate FPI investment in any G-sec issuance would be capped at 20% of the outstanding stock of that issuance. (a) and (b) are neither relaxation nor tightening measures. (c) is a tightening measure. April 2018 RBI withdrew the restriction on investment in G-secs with a minimum residual maturity of 3 years. However, an FPI could still not invest in any G-sec with a residual maturity period of less than 1 year in excess of 20% of the total investment of the FPI in that category. Relaxation June 2018 RBI re-allocated the sub-limits for investment among general FPIs and "long-term FPIs". The condition imposed in April 2018 with respect to FPI investment in G-secs with less than 1 year maturity was relaxed, and the cap was increased to 30% of the total investment of the FPI in that category. Relaxation March 2019 A new route for FPI investment, referred to as the Voluntary Retention Route, was announced. Under this route, FPIs were allowed to invest in G-secs of all maturities subject to conditions such as minimum investment size, lock-in period, etc. Neither relaxation nor tightening. Notes: 1. The entries in the third column are as per the authors' reading of the legal instrument announcing the intervention. 2. The third cell of the first row has been left blank as the entry summarises the legal framework till July 2014.

Table 2 shows that in a span of five years, there have been atleast eight changes to the rules for accessing the Indian G-sec market. In 2018 alone, there have been atleast two rule changes with respect to FPI investment in G-secs with a maturity period of less than one year.

These changes only pertain to the limits and caps on foreign portfolio investment in the Indian G-sec market. A comprehensive review of all the notifications issued by the RBI since 2000 shows that the rules governing foreign access to the Indian capital markets are, on average, revised nine times a year (Pandey et al., 2019). The maximum number of rule changes (42%) pertain to debt securities (both government and corporate debt).

A frequently changing policy regime creates uncertainty making it difficult for investors to plan ahead and hence, imposes implicit costs on market development. For FPIs to invest in Indian government bonds, global financial firms have to develop sufficient organisational capital in India in order to overcome India specific asymmetric information. This requires a sense of stability and certainty in the underlying regulatory apparatus. Frequent changes in norms disrupt the development of organisational capital.

When capital controls on foreign investment in debt markets are relaxed, at first foreign firms invest in liquid bonds. The magnitude of the intial investment may be small. As the investors gain confidence in the legal regime governing their access and also in the underlying macroeconomic environment, they start investing more in a broader range of securities. A deeper challenge is that of overcoming home bias, that is, the bias of investors to keep too much of their money invested in their home jurisdiction. Frequent changes in norms can amplify home bias.

In short, attracting long term foreign capital in the Indian market requires the creation of a stable, predictable and consistent regime that is not susceptible to flips-flops and frequent rule changes.

## Fragmented access

With the introduction of the FAR, there are now three routes under which FPIs may access the government debt market:

1. The Medium Term Framework (MTF) introduced in October, 2015 under which aggregate foreign investment is expressed as a percentage of outstanding bond issuances.
2. The Voluntary Retention Route (VRR) introduced in March, 2019 under which FPIs are required to retain their investments in G-Secs for a minimum period of three years subject to individual FPI based limits.
3. The newly announced FAR.

This framework is considerably more complex than the pre-2015 scenario where FPIs could access the Indian government debt market under a single set of rules. In October 2015, the framework governing capital controls on Rupee denominated debt changed from quantitative caps to percentage based limits. The framework referred to as the MTF thus envisaged percentage based limits on FPI investments in G-Secs.

The conditions of access under each of these three routes differ thereby resulting in a fragmented landscape. For example, while FPIs may invest in G-secs with a maturity of less than one year under the MTF subject to a percentage-based cap linked to the size of their investment, their investment in G-Secs under the VRR route is subject to a minimum commitment and a minimum retention period. On the other hand, if the investment is made under FAR, then none of these conditions applies.

## Missing economic rationale

An overarching rationale document explaining India's long-term strategy on capital controls is missing. For instance, under the FAR, FPIs can only invest without limit in G-Secs of three specific tenors. It is not clear why the liberalisation is being done in a select few securities as opposed to the entire G-Sec market. No explanation has been provided as to why the RBI specifically selected these three tenors, whether this selection is backed by an assessment of the FPIs' risk appetite towards long tenor securities or by any specific economic rationale.

By not allowing more G-Secs in the FAR route, RBI has effectively imposed restrictions on the access of FPIs to the overall G-sec market. External sovereign debt is a legitimate concern when the currency risk is borne by the sovereign borrower. This happens when the sovereign borrower issues debt in a foreign currency. In such cases, the debt liabilities of the sovereign borrower expand or contract depending on domestic currency fluctuations. Throughout the 1990s, emerging economies could not issue debt in their local currency, a phenomenon widely known as 'original sin' in the literature. The high proportion of dollar denominated debt issued by these economies made them vulnerable to currency crises.

Since the 2000s, however, emerging economies have been increasingly issuing debt in their local currencies and there is considerable risk appetite among the FPIs to invest in these securities (Burger et al., 2015). The ability to borrow in the local currency is a positive development that enhances financial stability by ameliorating the currency mismatches that were at the centre of past crises (Goldstein and Turner, 2004). When FPIs invest in Rupee denominated G-Secs in India, they bear the currency risk.

A glance at the data shows that relative to its peers, the approach so far followed by the RBI with respect to allowing FPI investment in Rupee denominated G-secs has been largely restrictive. Table 3 shows the foreign holdings of local currency government bonds in select Asian economies. For most of these economies, the foreign holding of local currency bonds exceeds that of India.

 % of outstanding LC bond issuance Indonesia 38.6 Japan 12.7 Republic of Korea 12.2 Malaysia 23.0 Philippines 4.9 Thailand 17.2 India 6.0 Source: Asian Bonds Online and RBI (as on September 2019)

### Conclusion

RBI's announcement is a step in the right direction. It might facilitate India's entry into the global bond indices and through this channel, foreign inflows into G-Secs might go up. However, more needs to be done to create a stable and consistent regime governing the FPIs' access to the G-Secs market.

The approach of notifying only specific securities in which foreign portfolio investment will be allowed without limits, indicates hesitation on the part of the RBI to open up the debt markets to unrestricted access by foreign investors. Over and above global bond indices, FPIs might be interested in separately investing in different tenors of G-Secs. Selective liberalisation by the government and the RBI pre-empts that possibility thereby missing out on larger volumes of foreign capital.

The design and announcement of the FAR route provides an excellent opportunity to reorganise the capital controls framework in order to simplify the underlying regulatory regime. For example, the VRR allotment data shows that only around 16% of the amount allocated under this route has so far been utilised by FPIs. This calls into question the rationale for introducing and retaining this framework over and above the existing rules of access. With the FAR now in place, perhaps the older routes can be phased out and gradually all of the FPI investment in G-Secs can be brought under this new route.

It is high time India embarks on a systematic path of capital account liberalisation by combining multiple routes into a single, well defined one, by reducing legal complexities and simplifying the capital controls regime. Letting go of this opportunity might prove to be costly for India in the long run especially when the world economy starts recovering from the ongoing crisis and there is enhanced appetite of FPIs for debt instruments in emerging markets.

### References

Patnaik, Ila, Malik, Sarat, Pandey, Radhika and Prateek (2013). Foreign investment in the Indian Government bond market, Working Papers 13/126, National Institute of Public Finance and Policy.

Burger, John D., Rajeswari Sengupta, Francis E. Warnock and Veronica Cacdac Warnock (2015). US investment in global bonds: as the Fed pushes, some EMEs pull, Economic Policy, CEPR;CES;MSH, vol. 30(84).

Goldstein, Morris, and Philip Turner (2004). Controlling Currency Mismatches in Emerging Economies, Washington, DC: Institute for International Economics.

Pandey, Radhika, Rajeswari Sengupta, Aatmin Shah and Bhargavi Zaveri (2020).Legal restrictions on foreign institutional investors in a large, emerging economy: A comprehensive dataset, Data in Brief, Volume (28).

Radhika Pandey is a researcher at NIPFP. Rajeswari Sengupta is a researcher at IGIDR. Bhargavi Zaveri is researcher at the Finance Research Group. The authors would like to thank three anonymous referees for valuable inputs.

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