Can RBI's Capital Flow Push Offset Global Yield Pressures?

India's current account deficit is facing fresh pressure. Crude prices have moved higher, exports are grappling with tariff-related uncertainty and foreign investors have remained net sellers in domestic markets. For years, remittances from Indians working overseas have helped cushion these pressures. That support, too, could come under strain if the conflict in West Asia drags on. The region accounts for nearly 38% of India's retail  remittance inflows.

The concern is not that India's external position has become unmanageable. Rather, the margin for error is narrowing. A higher oil bill and weaker remittance inflows are not immediate threats, but they are risks the authorities would rather not wait to confront.

The response has been swift. The RBI has widened access to government securities, eased investment restrictions for foreign investors and offered concessional swap facilities for overseas borrowing. Additionally, the government has added tax incentives, exempting certain foreign investors from taxes on interest income and capital gains.

Together, the measures are designed to make Indian assets more attractive at a time when foreign capital has become harder to secure.

Taken individually, each measure addresses a specific friction. Taken together, they amount to a broader attempt to bring foreign capital back into Indian markets at a time when global liquidity is becoming more selective.

The intent is understandable. Capital inflows help finance the current account deficit, support the rupee and provide an additional source of funding for both government and corporate borrowers. The question, however, is whether easing regulations and lowering transaction costs will be enough to attract capital in the current global environment.

Foreign investors already have several routes through which they can participate in Indian debt markets. The issue is not whether they can invest. The issue is whether the return on offer adequately compensates them for currency risk and the opportunities available elsewhere.

Five-year dollar funding for India's largest banks is available at roughly 4.5%-5.0%. Once hedging costs of around 3% are added, the effective borrowing cost approaches domestic funding rates. The strategy worked far better when US interest rates were close to zero and dollar funding was substantially cheaper than local borrowing. That advantage has largely disappeared.

The same argument applies to government bonds. Expanding the FAR route increases the investible universe and should improve market depth. But foreign investors ultimately focus on returns after hedging costs. India's 10-year government bond yield is around 7%. After accounting for hedging costs of roughly 3%, the effective yield pick-up moves to negative (as the US 1o year yields trade around 4.50%).

Yield Differential
This is where the global backdrop becomes critical.

The US economy continues to show remarkable resilience. Non-farm payroll data for May which came in at 172K was well above  expectations of 85K, suggest that the labour market remains robust and reduce the likelihood of aggressive rate cuts by the Federal Reserve. As long as US growth remains resilient, Treasury yields are likely to stay elevated.

That matters because US government bonds now offer investors something they lacked for much of the previous decade — meaningful returns with minimal credit risk.

The US 10-year Treasury yield is currently around 4.5%, not far from the 5.02% peak reached in October 2023. If yields move back towards those levels, the relative attractiveness of emerging-market debt could come under further pressure. Investors seeking safety would have little incentive to take on additional currency and market risk for only a marginal increase in returns.

(Source: investing.com)

None of this suggests that the RBI's measures are misplaced. On the contrary, expanding market access, removing investment restrictions and reducing transaction costs are sensible reforms. Over time, they should deepen India's financial markets and broaden the investor base.

The difficulty is that structural reforms cannot fully offset cyclical forces. Global capital tends to move towards the highest risk-adjusted returns, and at present those returns remain available in the United States.

The RBI can remove barriers. The government can offer tax incentives. But neither can change the fact that investors compare returns across markets before allocating capital.

If US yields begin to soften, India could benefit quickly given its growth prospects and improving market access. If they remain elevated, capital inflows may fall short of expectations despite the policy support.

The RBI and the government have opened more doors for foreign capital. Whether investors choose to walk through them will depend largely on the direction of global yields.

• Views are personal