India's latest interest-rate hike by the Reserve Bank of India (RBI) has failed to bolster the rupee, which has weakened further, nearing its record low against the US dollar. This depreciation, coupled with a sharp increase in currency hedging costs, is significantly eroding the attractiveness of Indian stocks and bonds for foreign investors.
Rising Hedging Costs Deter Overseas Investment
For international investors, the actual returns from Indian equities or debt instruments are not solely dependent on the asset's performance but also on the rupee's exchange rate. A weakening rupee can drastically reduce investment gains when converted back into foreign currencies like the dollar.
While hedging offers protection against such currency fluctuations, it comes at a price. Following the RBI's recent 25-basis-point policy rate increase – the first in four years – one-year hedging costs surged by over 60 basis points. This makes the effective return on Indian assets considerably lower, especially for those seeking to lock in their currency exposure.
"Lack of visibility of stability on the Indian rupee and a higher cost of hedging will mean that Indian equity assets will continue to be relatively less attractive," stated Ajay Marwaha, head of fixed income at Nuvama Group, in an interview with Reuters.
Foreign Capital Outflows Continue
The pressure from rising hedging costs arrives amidst an ongoing trend of foreign investors withdrawing capital from Indian markets. This year alone, foreign investors have pulled a record $30 billion from Indian equities. Debt flows have also turned negative since early September, according to Reuters reports.
Narrowing Interest Rate Differential Adds to Concerns
Another contributing factor to the reduced appeal is the shrinking interest-rate differential between India and major developed economies. The premium offered by India’s 10-year government bonds over comparable US Treasury and German Bund yields has reached its lowest point in years. Similarly, the interest-rate differential between India and the US is at a record low, diminishing the extra return investors might expect from holding Indian debt over US assets.
Global Factors Overshadow Local Policy
Sat Dhura, a portfolio manager at Janus Henderson Investors, indicated that while the RBI's rate hike might marginally slow capital outflows by reinforcing policy credibility, it is unlikely to reverse them independently. Dhura emphasized that the direction of capital flows would continue to be more influenced by broader global factors such as US yields, the dollar's strength, oil prices, corporate earnings, and valuations, rather than a single policy adjustment.
The combined effect of a weaker rupee, elevated hedging costs, and high global bond yields creates a challenging environment for Indian assets. The RBI may also face further pressure to tighten monetary policy if the rupee's weakness begins to fuel imported inflation.
Ultimately, for foreign investors, the decision to invest in India increasingly hinges on the net returns remaining after factoring in the crucial cost of protecting against a volatile rupee.