Why G-sec auction failed to lure FIIs? Experts discuss

The auction for permits to buy government securities got a muted response from foreign institutional investors (FIIs) on Wednesday.

The auction to buy nearly Rs 28,500 crore worth of government bond limits received bids for just Rs 20,496 crore. Meanwhile, only Rs 19,777 crore out of Rs 31,387 worth of corporate bond limits were sold. FIIs pay a premium for buying the permit to buy the bonds. The highest bid to buy a G-sec permit was just 0.01 basis points, which means even if they let it lapse they wont lose much. In an interview to CNBC-TV18 Ashish Vaidya, head- FICC Trading, UBS and Sameer Goel, Head Asia Rates & Currency Research, Deutsche Bank explained the reason for poor appetite among foreign investors to buy Indian government and corporate bonds, despite relaxed conditions. Bleak macro-economic outlook and policy paralysis is keeping foreign inventors from investing in India, said Goel. "We will require to see some progress on that before you see genuine interest from offshore investors come in a very significant manner." Agreeing to the reason citied by Goel, Vaidya also highlighted that this auction might not have been an attraction for arbitrage players also because of the hedging cost of rupee involved. "Any arbitrage player would want to hedge the dollars, so if he hedges the dollars, pays about 6-6.5% and if his internal funding cost is say 100-150 basis points it hardly leaves 50 basis points on the table," he said. Below is the edited transcript of the interview. Also watch the accompanying videos. Q: What are your key takeaways from this event – what explains this complete lack of interest on the part of FIIs? Goel: The auction for the quotas is not a surprise. This is ultimately an auction to buy the right to buy government bonds. We must also see that these are now auctioned every month on a more regular basis, so that is the positive side of it. Investors now have the option to buy this quota on a more regular basis that has driven down the premium people paid on this quota because the quota is now attached to the bonds you buy. If you sell the bonds you also lose the quota so it has become a more tradable instrument to that degree. Q: Give us a sense in terms of this 72% subscription that we did see or the interest that we did see, what sort of investors actually came in? What was the type of FII investor we were looking at? Vaidya: We really don’t have the break up of the type of FIIs. But if the real money guys if they are interested and they are ready to take an open risk on the INR then it clearly makes sense for an investor to come in. This does not augur very well for the arbitrage players because after taking off the hedging cost of US dollar INR it leaves nothing much on the table for an arbitrage player. Q: Would you agree with what Sameer that there is a broader macro India story that is going and that is creating disinterest or is it something else like for instance, one would always think that the arbitrage play, the interest rate that India offers 8-9% would be an attraction, not so? Vaidya: There is a hedging cost of rupee involved. Any arbitrage player would want to hedge the dollars, so if he hedges the dollars and if he actually pays about 6-6.5% and if his internal funding cost is say 100-150 basis points it hardly leaves 50 basis points on the table. So the arbitrage players will obviously step back and they will always be there despite whatever this story is there on the India macro. However, having said that I do agree with Sameer because broadly people look at areas and investor segments which are particularly impressive only if the overall macros attractive. Q: Was one factor the potential of rating downgrade because then a lot of people can’t even apply for these bonds was that a factor at all you think? Goel: The possibility of a ratings downgrade and that the agencies have put us on watch is certainly an important element. It differs according to investor classes that there is not necessarily all investors who would shy away from the market just because ratings go from being investment grade to being sub investment grade. Nevertheless a lot of investable criteria’s are linked to ratings. For the new investor who might wants to get into India the prospect of any ratings action in the next six months would certainly be an important factor. _PAGEBREAK_ Q: According to you these moves were actually made with regards to support the currency to a certain extent sometime back. Do you think that it would be more prudent to possibly tweak the withholding tax to spur demand going forward or increase the limits at this point in time because this 5 billion did not see that much of demand as it was anticipated? Goel: My view is that there are several different kinds of reforms which need to be done to make India more attractive for offshore investment. Now one category of this reforms is mostly certainly related specifically to debt markets and reducing or removing withholding tax on bonds certainly would go towards that direction. I would argue increasing the investable limits very significantly would be a very important element. That in particular would allow India to apply for and try and get included in global indices, which is where a large chunk of sticky long, buy and hold investment class gets in to. Those would certainly be reforms which are very much associated with debt markets and are needed. But my point also would be, the attraction for Indian assets is also tied in to the bigger macro picture which is about the hedging cost for the rupee. What is impacting that is the bigger macro picture in India and that requires policy reforms and some serious efforts to try and reduce the pressure on the currency at this point in time. So, you need to simultaneously work on several fronts to make Indian bonds as an asset. Q: The rupee is playing a very big role in the whole thing, making non sense of whatever returns you get on the interest rate front but since bonds that are sold off will once again be auctioned, so if one sees stability in the rupee do you think subsequent auctions would therefore become more attractive? Vaidya: It’s important to figure out what kind of investor segment is coming in. If you have somebody like a sovereign wealth fund coming in who is trying to diversify reserves then they would come in with an open investment in INR. In that case it will make sense, the outright yields. If the money that comes in is mainly on account of arbitrage then that money will only be a function of what is your hedging cost, so if the hedging cost goes down and your interest rates remain where they are here then you will see a lot of interest from the FIIs. Q: What is the message from the rupee from this? Do you think the appreciation will come to a halt? Vaidya: This would more or less have a physiological impact on the people so basically we are talking about the sentimental impact. But having said that, let us look at how the equity markets behave because over the last few weeks we have seen a lot of brokerages upgrade the Indian equity markets. It is looking like a value so if that continues and we see some policy measures actually coming through then certainly I think this should be around the toppish levels or maybe another 50 paisa from here. Q: What is the range you are looking at for the rupee? Vaidya: A very broad range would be basically between 53/USD to 55.50/USD. I really don’t think 55.50/USD is breaching in a hurry. Unless you see no policy actions from the government over the next 2-3 months then again you are going to be falling into a trap. Q: What do you think is the trend for the rupee going forward and today obviously would be more of a sentimental reaction as a post of fundamental? Goel: Yes, I think to some extent if the markets were and I would be surprised if they were, but markets were really looking for the bond auction as a justification for a lot of significant flows to come in, in the near term and that’s why dollar-rupee was going lower then – I guess you could argue that there is a reversal of that sentiment. But more broadly speaking I would argue that, the idiosyncratic move in the rupee is done and over. To that extent we have in my opinion seen the tops as far as the dollar-rupee is concerned.From hereon and you cannot certainly dismiss dollar-rupee going still further higher, but at will be at best a beta to what happens to the regional as a whole. There is a much bigger global picture in dynamic which is at play here which we must not forget. Now it is possible that some of that goes on a little bit of a slow burner in the third quarter with all the global news we have seen thus far but it’s never really away. So, to me rupee is now a lot more of a beta play than it was in the second quarter. Q: What is holding up the yields at this point in time is it hope of OMOs and what is the broad direction- does it go towards 8 or does it go towards 8.25%? Goel: I think 8.25% is not very far from where we are so that is almost like saying it is going to hold par. I do feel yields have topped out here. The top might be another 10-15 bps very possible, but really what is holding up now the bonds markets is the fact that expectation that liquidity comes in more. There are talks about payment of dividends which RBI will do to the government, there is very clearly an improvement in liquidity as some of the export refinance has been used. RBI is very clearly committed that they would use of open market operations as a tool to manage liquidity. The Deputy Governor was talking about disconnecting the rupee liquidity intervention from the dollar intervention that they have done. All those factors do play in the minds for the market. Ultimately, there are expectations that the central banks would cut rates down the line, whether that happens in a month’s time or six months time, but that we have seen the peak as far as the interest rate cycle is concerned. All those things do factor in. If they were expectations build up around these debt auctions, quota auctions they seem to have reflected much more in the currency markets then they were necessarily in the bond markets.