The Exodus of Foreign Investors: $1 Billion Pullout from Indian Debt

For four years, foreign portfolio investors (FPIs) were like eager guests at the Indian debt market’s banquet, showering the table with over ₹80,000 crore of investments. But the year 2023 witnessed a dramatic shift, with FPIs turning their backs on the long-term debt segment, pulling out a staggering ₹8,089 crore from the Voluntary Retention Route (VRR). This unexpected exit, akin to a silent departure amidst a bustling party, raises questions about the reasons behind this sudden change of heart.

The VRR, introduced in 2019, was envisioned as a red carpet for long-term foreign investments in Indian debt. Unlike regular FPI investments, VRR investments were shielded from stringent regulations and offered the allure of a concessional 5% withholding tax. But like any meticulously laid feast, the VRR’s appeal seems to have dimmed for foreign investors. Let’s delve deeper into the key factors fueling this exodus.

The Disappearing Appetizers: A Famine of Stressed Debt and Auctions

One major reason for the FPIs’ disenchantment is the dwindling availability of “stressed” or “structured” debt – the spicy delicacies that once piqued their interest. Ajay Manglunia, MD & Head of Investment Grade Group at JM Financial, points out that the aggressive cleanup of corporate stress has left fewer distressed assets on the menu. Moreover, the scarcity of VRR auctions, crucial for new investors to acquire their investment limit, has further dampened their appetite.


The Tax Tide Turns: From Sweet Concessions to Bitter Reality

For investors with a three-year horizon, the end of the 5% concessional tax benefit in 2022 proved to be a bitter aftertaste. The effective withholding tax now stands at 20%, significantly reducing the net returns for FPIs. Suresh Swamy, Partner at Price Waterhouse & Co., emphasizes the impact of this policy change, highlighting the need for a “balanced fiscal approach” to maintain market competitiveness.

Hedging Hangover: The Dollar Dilemma

Adding to the woes, Manglunia argues that after factoring in currency hedging costs of around 4%, investing in developed markets like the US, with their rising yields, offers a more palatable option. He illustrates this with a hypothetical scenario: even with a 10% coupon rate on a ₹1,000 bond, the 20% tax and 4% hedging cost shrink the FPI’s net return to a meager ₹40, a 27% drop compared to the earlier tax regime.

A Temporary Retreat or a Lasting Farewell?

While the current selloff paints a picture of discontented investors, experts urge caution against hasty conclusions. Yashesh Ashar, Partner at Illume Advisory, suggests that the exodus could be partly driven by portfolio re-alignment and the anticipation of further rupee depreciation. He believes that sentiment may improve, especially with the recent increase in the VRR investment limit to ₹2.5 lakh crore.

Beyond the Headlines: A Holistic Perspective

Understanding the FPI retreat requires looking beyond immediate triggers. Factors like global economic uncertainties, changing risk appetites, and evolving regulatory landscapes play a crucial role in shaping investment decisions. A nuanced analysis of these intertwined elements is necessary to predict the future trajectory of FPIs in the Indian debt market.

The Road Ahead: Rekindling the Allure

Retaining the allure of the Indian debt market for FPIs hinges on proactive measures. Addressing concerns around tax stability, ensuring a steady flow of attractive investment opportunities, and streamlining regulations are critical steps. Additionally, leveraging India’s upcoming inclusion in global bond indices could present a unique opportunity to woo back foreign investors.

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