According to Reuters, the cost of protecting against further rupee weakness has also jumped sharply. One-year hedging costs rose by more than 60 basis points this week following the RBI’s decision, making Indian assets less attractive to overseas investors when currency risk is taken into account.
For a foreign investor, returns from Indian equities or bonds depend not only on the performance of the underlying asset but also on movements in the rupee. A weakening currency can erode investment gains when returns are converted back into dollars or other foreign currencies.
Hedging can protect investors against that risk, but the protection comes at a cost. When hedging becomes more expensive, the effective return from Indian assets falls, particularly for investors who want 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,” Ajay Marwaha, head of fixed income at Nuvama Group, told Reuters.
Foreign investors continue to pull money out
The pressure comes at a time when foreign investors are already withdrawing substantial money from Indian markets. Foreign investors have withdrawn a record $30 billion from Indian equities this year, while debt flows have turned negative since the beginning of September, Reuters reported.
The narrowing interest-rate differential between India and major developed markets is another concern. The premium offered by India’s 10-year government bond over comparable US Treasury and German Bund yields has fallen to its lowest levels in years.
India’s interest-rate differential with the US is also at a record low, reducing the additional return that investors can earn by holding Indian debt rather than US assets.
RBI faces pressure from global factors
Sat Dhura, portfolio manager at Janus Henderson Investors, said the RBI’s rate hike could slow capital outflows at the margin by reinforcing policy credibility, but was unlikely to reverse them by itself.
“The direction of flows will continue to depend more on US yields, the dollar, oil prices, earnings and valuations than on a single 25-basis-point move,” Dhura told Reuters.
The combination of a weaker rupee, higher hedging costs and elevated global bond yields therefore creates a difficult backdrop for Indian assets. The RBI could also face pressure to tighten monetary policy further if currency weakness begins feeding into imported inflation.
For foreign investors, the issue is increasingly not simply whether Indian stocks and bonds offer attractive headline returns, but how much of those returns remain after accounting for the cost of protecting against a weaker rupee.
