MFs Rushing In Where FIIs Fear To Tread

The FIIs’ recent scramble away from the emerging markets has seen MFs swooping in to invest in the debt space. Is this an indication of a grossly myopic trend? Are the gains from these investments worth the risk of monetary tightening in these markets? Amit Bhanot answers

The rupee storm is far from over, and is in fact gaining strength with each passing day, with the Indian currency tumbling by two per cent against the greenback in just five days in July and touched an all-time low of 61.21 per dollar on July 8. Since April 2013, the rupee has crumbled by more than 13 per cent.

The biggest reason for this decline in the rupee is certainly the panic sell-off by FIIs from emerging markets (EMs) including India owing to better-than-expected recovery in the US and the Federal Reserve’s announcement of curtailing the third round of quantitative easing (QE3) by the end of 2013. In fact, FIIs are selling heavily in the debt markets across EMs, as they are getting better risk-free relative returns in the US now. The announcement of liquidity squeezing has only helped the situation.

The extent of the exodus can be gauged from the fact that FIIs sold assets worth over Rs 33000 crore in June 2013 and Rs 6597 crore in just the first five days of July in the Indian debt market. Experts are of the opinion that this exit will continue in the coming time, because FIIs have big positions in the debt markets of countries like India. The present situation of reversal in the economic trend from cheap money to liquidity squeezing by the US will force them to exit the EMs.

FIIs Panic, MFs Gain

While FIIs are pulling out, Indian mutual funds and banks are taking big positions in the debt markets, as panic selling by FIIs is providing them with a good opportunity to make a quick buck. As FIIs are selling, Indian mutual funds have purchased booty worth Rs 64602 crore and Rs 18826 crore in June and July respectively in the debt markets. “The selling by FIIs in June was absorbed by MFs and banks to some extent. The yields have softened in July and so in hindsight, MFs have observed some gains on this account”, says Killol Pandya, Senior Fund Manager – Debt, LIC Nomura Mutual Fund.

Almost all mutual funds have invested hefty sums of money in the debt market in June, and as per the estimates, the short-term returns have shot up to 12-15 per cent annualised for this period. In fact, such a quantum of fluctuation has never been seen in the debt market. Owing to the decline in the rupee, the bond yield has spurted. On June 20 alone, when FIIs sold debt worth Rs 3062 crore, the bond yield swelled by 10 basis points, triggering a rare circuit in intraday trades.

In the short term, this has given a good opportunity for bonds as there is an underlying perception in the market that the RBI and the government will ultimately intervene to arrest the rupee’s free fall and sooner or later the rupee will stabilise at some level. This gets even more interesting if we see the MFs’ activity on the bourses. MFs were net sellers in June as well as July, giving an indication that they don’t have an optimistic view on equities.

Apart from gains, there is another factor spurring debt investment. As there is a huge volatility in gold, equity and forex, MFs and domestic banks are now parking their money in the debt markets as they consider it to be much safer and less volatile. Sure enough, they have made a real killing with this strategy.

Professor N R Bhanumurthy, Professor and Secretary, Indian Econometric Society, National Institute of Public Finance and Policy, concurs with our view saying, “Integration of financial markets has taken place in terms of assets. As volatility is increasing in gold and forex markets, a shift of investment has taken place to the equity and debt markets. In fact, domestic banks have shifted their forex investment to other assets”. However, Bhanumurthy adds, “As the markets are integrated, we are now seeing volatility in the other markets too”.

The Underlying Threat

Though MFs have made handsome gains over panic selling by FIIs since May and they continued that trend in July also as MFs have overall optimistic view for the Indian economy. Also considering the present phase, in spite of the recent sharp decline in the rupee, the overall view of the fund manager is that if the currency stabilises, the RBI will certainly cut interest rates to push growth. If this would happen, their debt investment would become more profitable. In fact, an official from a top fund house said that investment in debt is happening over the perception that though it is not easy for the RBI to cut rates now, there isn’t any possibility of any kind of interest rate hike either. Spurred by this rationale, funds are parking their money in debt almost blindly.

This strategy of MFs certainly holds water in a scenario where there is stabilisation in the rupee, but it is equally possible that the current situation evolves to take a very different shape. Currently, the RBI and the government seem more preoccupied with volatility than they are with the depreciation in the rupee. “To arrest this volatility, there are two ways available; either curtail fiscal deficit or go for monetary tightening to reduce the money in circulation. So, instead of reducing the interest rates, the RBI may even increase interest rates or tighten the CRR. It is really a catch-22 situation for the RBI”, Bhanumurthy opines.

Some key emerging markets like Brazil, South Korea and Turkey have, in fact, given a clear indication of monetary tightening. So, if there is an increase in interest rates, the whole situation for MFs’ debt holdings will change. There will be a huge loss in the current investment, as it will become unattractive.

Will FIIs Come Back?

The biggest worry for EMs like India is not the panic exit of FIIs in last two months but more so the trend and volume with which this exodus is happening. As per research company EPFR Global, FIIs sold assets worth more than USD 10 billion in the week ending June 28.

The differential returns from the debt markets in EMs are also narrowing down in comparison with those in the US. The 10-year US government bond yield has spurted from 1.95 per cent to 2.46 per cent in a matter of less than two months, while the Indian benchmark 10-year bond yield remains at 7.47 per cent. Considering the enormous volatility risk in the rupee and the hedging cost, it is becoming unattractive for FIIs to remain invested in the Indian debt market (or any other EMs for that matter) as the differential return is narrowing fast. We have seen a flight of capital towards the US for this reason. However, given the scale of investment by FIIs in EMs – USD 4.2 trillion since the Federal Reserve started its QE programme – this is just the start.

“We have to understand that this is not a mere trading activity by FIIs but a decisive exit from emerging markets like India. In such a situation, it is not wise for MFs to purchase into debt market as FIIs will continue their sell-off considering Federal Reserve’s monitory tightening”, explains Jagannadham Thunuguntla, Head – Equity, SMC Global. Till now, FIIs have moved out only around Rs 9000 crore from the debt markets, but they have a position of Rs 1.40 lakh crore in debts and Rs 6.46 lakh crore in equities. “If they continue their selling spree, then those purchasing in the market will be in huge danger as the era of cheap money is over”, Jagannadham concludes.