RBI doesn't want to go FAR

The Reserve Bank of India just made some foreign investors very unhappy . Out of the blue, it slapped a restriction to prevent them from buying some of India’s government bonds. And we’re going to tell you what’s going on.

But first, let’s start from the top.

See, India has always been wary of ‘hot money'.

And if you’re wondering what that is, it’s the nickname given to money invested by Foreign Portfolio Investors (FPIs). It’s called hot money for a simple reason?—?they’re quick to flood a country with money when times are good, but if they see a problem on the horizon they’ll quickly pack up their money suitcases and ship it elsewhere. Their money is quite fickle.

And that fickleness is the problem. Because when hot money exits, it can leave a trail of destruction in its wake.

Remember the Asian Financial Crisis of 1998?

Back then, interest rates were quite high in Asia. So foreign investors flocked to places like Thailand and Malaysia. They bought short-term bonds and doled out loans. And that influx or supply of money led to interest rates falling. It spurred governments and companies to borrow even more money.

Eventually, cracks in the economy started to show up partly thanks to this excessive borrowing.

You can guess what happened next by now. Foreign investors got nervous and they asked for their money back. And that sudden mass outflow led to interest rates shooting up again and the currency dropping in value. That put a full stop to all economic activity and hurt Thailand and its neighbours for years to come.

But thanks to India's central bank and government being wary of this sort of hot money, our bond markets were sheltered from this storm.

The RBI had placed limits on how much of the total government bonds FPIs could own and it didn’t allow FPIs to even buy bonds that would mature within 3 years. It wanted only those investors who would play the long game.

And those rules meant that, until recently, foreigners owned only 2% of all Indian government bonds.

But as our economy grew stronger over the decades, we started wondering if that should change. We debated whether we should keep the door ajar in the bond market. After all, foreign investors were pumping money into our stock markets. And they were clamouring to get a bigger piece of bonds too.

So in 2020 , we opened the door.

The RBI introduced a new set of bonds that would be tailor made for FPIs. It was called FAR bonds or Fully Accessible Route bonds. It wouldn’t have those pesky limits and FPIs could buy these bonds easily. Bonds with all sorts of maturities would be part of FAR?—?3 years, 5 years, 10 years, and even 30-year bonds.

India was finally welcoming the hot money.

In fact, in quite a big way. Because BlackRock estimates that FAR bonds make up 36% of the total government bond market in India and there’s around 38 FAR bonds of varying maturities that FPIs can buy today.

But something else also happened as a result of the new FAR bonds.

Foreign bond indexes got excited.

Now these are indexes like the Nifty 50 but for bonds. It’s managed by folks like JPMorgan and it’s up to them to decide which country’s bonds are allowed as part of their index. And how much of the country’s bonds should be part of it. So if they like India, they could add us to it and say, “We like you so much that 10% of our index will be your bonds.” And once it’s in the index, every bond fund in the world that mirrors the index?—?the passive funds?—?will buy Indian bonds too.

And 4 years after India introduced the FAR bonds, JPMorgan added India to one of its bond indexes in June 2024. It decided that it would allocate 1% weight to Indian government bonds every month over the following 10 months until Indian bonds formed a grand total of 10% of the index.

In a way, it was cause for celebration. Our bonds had made it to the big stage.

But then, a couple of weeks ago, the RBI poured cold water on FAR bonds. It told FPIs, “Hey, we’re making the 14 and 30-year government bonds off limits for you.”

And this is a bit weird for two reasons.

Firstly, if you remember, we told you earlier that in the era before FAR bonds, the RBI only wanted foreign investors to invest in long-term bonds. But now, in the FAR era, they’ve taken that out of the equation.

Also, it’s an odd time to introduce this restriction since it’s coming on the heels of global bond indexes finally warming up to us.

So, what on earth is going on?

Well, since the RBI really hasn’t given much clarity as to why they suddenly imposed these restrictions, we’re going to have to make an educated guess.

Now the most plausible explanation would be that ever since we found a place in the JPMorgan bond index, a lot of FPI money has found its way into the 14 and 30 year government bonds. So maybe the RBI felt that there’s too much hot money concentrated there.

But that would actually be a wrong assumption to make.

Because a few days after the announcement, the deputy governor of the RBI himself said that 90% of foreign investments in FAR bonds are in ones with 5 to 10 year maturities.

So that seems to be where the hot money really is. It’s not in the 14 and 30 year bonds.

Then why even introduce these new restrictions?

Well, another statement that the deputy governor made might actually give us some insight. He said and we quote,

“Our hope is that concentrating them in this 5- to 10-year segment will actually make it more liquid and better price discovery will occur and transaction cost will fall as the depth increases.”

Ok, to make sense of what that could mean, think of what happens when a government issues a bond to borrow money. It has to pay interest on it, right? And naturally, the government would want that interest outgo to be as low as it possibly can.

But how can it nudge that interest rate or yield lower?

By increasing demand for its bonds, of course.

And if you’re wondering how that will help yields, hear us out?—?Imagine the government is selling a bond that matures in 1 year for Rs 100. And it promises to pay 5% interest on it. This means that if you buy this bond, you will get Rs 105 at the end of the year.

So your return or yield is 5%.

Economic theory says that when demand exceeds supply, it will lead to a price rise. So if people clamour to invest in the bond, its price could rise to Rs 101.

Now if you bought the bond for Rs 101, you won’t get that amount when the bond matures. Rather, you will only get Rs 100. And you will get Rs 5 in interest as well.

So you spent Rs 101 and you received Rs 105. Ergo, your return or yield from the investment is lower. It’s only 3.9%

Now by shutting access to the 14 and 30 year bonds, the RBI could nudge the FPI flows into the 5 and 10 year bonds. It will lower the yields in this segment. And since this segment accounts for 45% of government bond issuances, maybe it will help the government sell new bonds at a much lower yield. It will save some money.

Maybe.

As we said, this is just an educated guess. And we don’t really know if that’s what the RBI is thinking.

What do you think?