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Premium: The Dangerous FII Debt Situation and The RBI’s Fear of Speculators


Premium: The Dangerous FII Debt Situation and The RBI’s Fear of Speculators

This is a premium post for Capital Mind Premium subscribers, sent on Feb 17, 2014. Subscribe now!

Let’s take a look at another outlier we’ve started to see: That FIIs can no longer invest easily in Indian debt markets, and this might be a big change for the rupee/dollar exchange rate.


RBI seems to be getting back into extreme micromanagement mode, with another sub-limit decrease on corporate bond investments. What they already have is a set of zany restrictions on what foreign institutions can buy, in terms of Indian corporate and government debt.

  • FIIs can buy only upto $20 billion of Government debt.
  • FIIs that come under a regulator abroad (insurers, pension funds, sovereign wealth funds etc.) get to buy another $10 billion, on “tap”.
  • Of this $30 billion, only $5.5 billion can be in treasury bills (short term govt debt)
  • And the conversion rate is around the Rs. 50 levels to a dollar, because the limit was converted to rupees on the day of the limit’s announcement. Since the rupee is now 62, the actual limits in dollars is lower.
  • Corporate bonds have a $51 billion limit
  • Of which $3.5 billion was the limit in short term /commercial paper.
  • Another limit of $5 bn is there for “credit enhanced bonds”, again within the $51 billion overall limit.

On top of that there used to be an auction mechanism. As an FII, You want to buy debt? You have to bid for the privilege and pay a fee to hold that limit, and compete with everyone else; and then if you bought some bonds and sold them, you couldn’t use the proceeds to buy more. You had to wait till the next auction, bid for your stuff etc.

Recently the auction mechanism has been disbanded as long as FIIs own less than 90% of the above mentioned limits. Above 90% the auction will have to happen.

FIIs hitting the limit in short term paper

So where are we? At this point, FIIs are close to their limits on short term government paper (T-Bills). While the limit we tell them is $5.5 billion, we translated that to the rupee amount at a conversion rate of less than Rs. 50, which means they can only buy Rs. 25,416 cr. worth of T-Bills, and that is only $4 billion nowadays. They’re at 95% of that limit:

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A new limit in Commercial Paper

Commercial Paper is short term debt issued by the private sector. Companies like PFC and Piramal Healthcare and all of them issue short term paper.

In Commercial Paper, FIIs have been buying substantial amounts, and because of that, the RBI has again reduced the limit from $3.5 billion (within the overall limit of $51 billion) to just $2 billion. Because of exchange rate differences the limit is down about 30% to 12, 455 cr. out of which FIIs have already bought 11,000 cr. (90%).

Premium: The Dangerous FII Debt Situation and The RBI’s Fear of Speculators

FIIs care Largely About Short Term Debt

In the last few months, more than 60% of daily change in holdings is in short term paper (T-Bills or Commercial Paper).

In fact, FIIs have cut exposure to corporate longer term paper (now 68,500 cr. after being at 79,500 a year or so back) to increased exposure in short term paper.

FII investments in India: Highest since September 2013

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(This has largely been due to the increase in holdings of short term paper)

While this investment is still only 38% of the FII total investment limits of 398,000 cr. , the concern is that it is this high only because of short term debt, which for FIIs has reached its limits.

Impact on the dollar: FII flows since January are largely Debt

If you look at FII flows, they have mostly been in the debt markets since Jan 1, 2014. Equities have been negative.

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This fund flow has helped the USDINR which still trades around the Rs. 62 mark.


Let’s summarize:

  • India has weird sub limits on what FIIs can buy and what not
  • FII investments are close to the limit on short term paper
  • FIIs have, in recent times, been mostly interested only in short term paper.
  • FII flows since Jan 1 have been mostly in debt markets, not equity
  • FII flows determine the movement of the dollar rupee exchange rate
  • The RBI wants to curb FII interest in short term paper.

If FIIs won’t bother about debt anymore (since they are mostly interested in short term paper where they have reached their limit) then we are likely to see:

  • A rise in the dollar-rupee exchange rate
  • A rise in yields in TBills and Commercial Paper (as a big player steps out)
  • A fall in equity markets because this is effectively means higher interest rates for companies.

One possible trade here is to go short the rupee, but remember that the RBI is very active in the currency market and they can chop you off unless you’re reasonably capitalized.

Secondly, the short term yield curve is already under some stress (due to liquidity and solvency issues) – the curve could get inverted as short term yields rise; here, short term debt mutual funds will initially lose money. You could exit and get back in to make a small profit, but it’s better to start moving funds from other investments into short term instruments to get a substantially higher return.

Thirdly, the trade is to go long IT and Textile export stocks. A fall in the rupee only helps them.

We aren’t taking any of these as positions right now, and would like to see how markets react on Monday. The RBI announcement to cut CP debt limits came after markets closed.

Capital Mind Premium brings you outliers with the appropriate analysis you need to understand why this is an outlier. We hope you liked this one as much as we liked writing it!

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Nothing in this newsletter is financial advice and should not be construed as such. Please do not take trading decisions based solely on the matter above; if you do, it is entirely at your own risk without any liability to Capital Mind. This is educational or informational matter only, and is provided as an opinion.

Disclosure: The authors at Capital Mind have positions in the market and some of them may support or contradict the material given above, or may involve a direction derived from independent analysis.




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