Mumbai: The economic logic for foreign funds to invest in domestic debt instruments is withering away as yield differentials are narrowing fast, owing to a steep fall in the rupee, a senior SBI official said Tuesday.
The official also said looking at the real interest rate and the macro fundamentals of the economy, the rupee has to depreciate by 5 percent every year.
"The rupee fall is primarily due to (US Fed Chairman) Ben Bernanke's statement of a possible QE3 slowdown. Also, the US interest rates have gone up of late. If you see yield of 10 year US treasury is more than 2.21 percent.
Kumar further said while the 10-year benchmark yield in the domestic debt market is hovering around 7.3-7.4 percent, arbitrage opportunity for the FIIs is fast squeezing in the domestic market because of higher hedging cost due to fall in rupee.
"So, the economic logic in investing here is not there as the hedging cost will be around 6 percent for FIIs, prompting them to pull out their investment," SBI deputy managing director and group executive for global markets P Pradeep Kumar told PTI during an interaction.
Currently, the US treasury note for 10 year hovers around 2.1 percent, while it is around 7.3 percent for Indian 10-year benchmark yield. However, when FII takes an exposure in Indian bond, he has to hedge it against exchange rate risk, which comes around 6 percent.
So, the effective return for FII comes to 1.3 percent (7.3 percent minus 6 percent) as of now in Indian bonds, in comparison to 2.1 percent offered in US 10 year treasury note.
Kumar also said the rupee has to depreciate by at least 5 percent every year on the basis of macro fundamentals. "In the long-run, the rupee has to depreciate because there is both interest rate and inflation differentials between the US and India," he said.
Referring to the short-term movement of rupee, Kumar said it will depend on the flows.
The domestic currency has lost over 7 percent since the first week of May on the back of pulling out of foreign flows, which was around USD 3.9 billion from the debt market, due to apprehension of tapering of the US stimulus.
The rupee today sank by a whopping 90 paise to all-time closing low of 58.77 on massive dollar buying by banks and importers as forex markets became jittery ahead of Fed's decision on continuing monetary stimulus.
On possible inflows by FIIs, he said inflows would come into the country if the interest rate differential between the domestic economy and US hovers around 6 percent or more.
"It will depend on how interest rate pans out...If the interest rate differential between US and India is above 6 percent...Then money will come...My personal view is that it is going to be difficult unless they take a very long call and they put money for long-dated and hopeful that economic growth of the economy will improve and consequently, rupee will appreciate...This is a very long call not short-term call," he said.