If anything, an improvement in India’s domestic and external fundamentals, along with events like the inclusion of domestic debt in global bond indices, has prompted foreign investors to pour funds here, a compressed rate differential notwithstanding.
“Academically, the narrowing of the US-India rate differential is likely to put pressure on capital flows and eventually on the currency as well. However, India is in a unique position right now. In terms of external sector vulnerability metrics, we are the lowest in more than 10 years,” said Kanika Pasricha, chief economic advisor at Union Bank of India.
“Importantly, we are actually in a position where services exports are spiking. Despite oil prices at $85-90 a barrel, we are able to manage with a current account deficit of less than 2% of GDP,” she said.
Data compiled by ETIG showed that the average Indian 10-year government bond yield so far in 2024 was at 7.12%, 291 basis points higher than the average US 10-year bond yield of 4.21% over the same period. In 2023, the average yield gap was at 326 basis points, the lowest since at least 2007, when the gap was at 332 basis points, the data showed.
From 2014 to 2022, the yield on the Indian 10-year bond was higher than the US 10-year bond by 504 basis points on average.The compression has occurred as the Fed raised interest rates at a faster pace than the RBI to tackle runaway inflation in the US in 2022.
FPIs Rush In
Usually, a lower interest rate differential between Indian and US bonds triggers outflows from debt markets as foreign portfolio investors (FPIs) find domestic debt less attractive amid higher debt returns in the world’s largest economy. This, in turn, can exert pressure on the rupee as it did during the taper tantrum of 2013 when $7.9 billion worth of net FPI outflows from Indian debt occurred and the rupee depreciated 11% against the US dollar in that calendar year.
So far in 2024, however, FPIs have net purchased $5.8 billion of domestic bonds and the rupee has shed a mere 0.2% versus the US dollar.
“Whether you look at external sector resilience, the credibility of policymakers, everything creates its own virtuous cycle to keep the rupee where it is and the kind of inflows that India continues to attract. The interest rate gap is one of the factors,” said Anubhuti Sahay, head of South Asia economic research at Standard Chartered Bank.
“If other factors are on a solid footing, then probably you will not see the typical textbook theory playing out that narrower interest rate spread leads to outflows from countries like India,” she said.
STABLE MACROS bolster FLOWS
While the yield differential had narrowed in 2013 over 2012, in absolute terms the difference was at 579 basis points, a much larger gap than exists now. This buttresses the view that macroeconomic factors such as a much larger corpus of foreign exchange reserves, efforts at fiscal consolidation and growing heft of services exports have led to greater external sector resilience.
Earlier this month, the RBI’s foreign exchange reserves touched an all-time high of $648.56 billion. The central bank said that at $643.2 billion as of April 12, the level of reserves was enough to cover 99% of total external debt outstanding at December-end 2023. In May 2013, the month that the taper tantrum broke out globally, the RBI’s reserves were at $292 billion.
“Despite narrower differentials, ECBs and other debt inflows continue. More than higher Indian rates it is the lower country risk, a stable currency and higher expected growth that keeps FPI here,” Ashima Goyal, a member of the RBI’s Monetary Policy Committee, said in October last year.