Amid the vagaries of global economic cycles, the Reserve Bank of India’s role in managing international flows has also evolved greatly, with the central bank having expanded its toolkit when it comes to adroit handling of the liquidity impact on the domestic banking system.
In the current scheme of things, a member of the RBI‘s Monetary Policy Committee says a phenomenon that could otherwise have been a cause for concern may in reality open up room for the central bank to achieve another crucial task.
The phenomenon in question is a rapid outflow of foreign institutional investment from Indian equity markets.
Ordinarily seen as a manifestation of external volatility, in the prevailing context, the departure of FII funds from Indian markets could provide room for the RBI to lend a helping hand to the sovereign borrowing programme, said Dr Ashima Goyal, member of the MPC.
“Sustained equity outflows are unlikely in view of India’s growth potential. Moreover, some outflows will give more space to support government borrowing without raising durable liquidity. In any case room has been created to rebalance any rise or fall in liquidity, as required,” Goyal’s statement in the minutes of the MPC’s February meeting read.
“The interest differential with the US is large. Their real rates remain highly negative. Since interest sensitive foreign flows are still a small percentage of Indian markets, potential outflows are a minuscule portion of India’s large foreign exchange reserves.”
In the current calendar year so far, FIIs have made a beeline to reduce their holdings of Indian equities due to a combination of factors including the likelihood of multiple interest rate hikes in the US and more recently a surge in crude oil prices following the Russian invasion of Ukraine.
With India importing a bulk of its oil requirements, the hardening of crude oil prices has worsened the outlook on the current account deficit and inflation.
Data released by the NSDL shows that FIIs have pared their holdings of domestic stocks by a massive Rs 77,085 crore. Taking into account the Rs 38,521 crore of net sales from October to December of 2021, the FII outflows are at their largest since the global financial crisis of 2008.
On the debt side, foreign portfolio investors have shrunk their net holdings of sovereign bonds under the general category by Rs 1,788 crore so far in 2022, although holdings of specified securities under the fully accessible route show a net increase of Rs 2,879.5 crore, according to CCIL data.
From an FDI perspective, however, the flows remained firm, with the country receiving total foreign direct investment of $60.3 billion during April to December 2021.
Window to aid borrowing?
As Goyal pointed out, from the RBI’s perspective, some degree of overseas outflows could provide some elbow room when it comes to the delicate balance of liquidity and government borrowing.
The huge surplus of liquidity in the banking system, currently estimated in excess of Rs 8 lakh crore, is a challenge for the RBI, given that global and domestic inflationary pressures are on the upside.
However, any sign of the excess cash being permanently drained out– as opposed to the short-term rebalancing conducted through variable rate reverse repos –could lead to a surge in government bond yields in the face of a huge sovereign borrowing programme.
Given that the success of its bond sales is crucial for the government’s aim to spend more and revive growth, the RBI cannot risk upsetting the smooth passage of the borrowing programme.
Equities too could witness volatility as a portion of the surplus cash sloshing around in the system has found its way to the stock market, lifting up valuations.
In this backdrop, the overseas outflows give the RBI an option which had been seemingly ruled out – purchase government bonds from banks and replenishes the foreign liquidity leaving the system.
This would provide some much-needed improvement in bond supply dynamics as the RBI emerges as a buyer and at the same time would not present the risk of even more addition to surplus liquidity.
“The RBI it seems has already sent out a few subtle signals,” a senior bond trader at a large foreign bank said.
“They chose to announce an FX sell-buy swap which takes out rupee liquidity; that provides some room to buy bonds. Now, if the FII outflows continue at this pace, they could have more comfort in stepping in to do OMOs. This takes off some of the pressure when it comes to handling liquidity,” he said.