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India's debt market is the best performer among major emerging market economies, in sharp contrast to last year.
Worried by potentially destabilising hot money flows, the Reserve Bank of India (RBI) could take action if foreign investors pour excessive amounts into mutual funds to bypass limits on ownership of government debt,according to a senior policymaker.
Foreign institutional investors (FIIs) have almost reached their $25 billion limit on direct holdings of government debt, but have begun raising their exposure by investing through debt-focused domestic mutual funds.
"This is a way of working around the rule," the policymaker, who has direct knowledge of the RBI's thinking, told Reuters.
"If the flows become quite high into g-secs (government bonds), then we may have to take some action with SEBI," he added, referring to the Securities and Exchange Board of India.
During the first two weeks of November, 30 billion rupees ($484 million) flowed into these funds, raising total foreign investment in them to 110 billion rupees, according to several fund executives, citing data tracked by clearing and depository agencies.
"It doesn't look like a big amount has come through this route yet, but we are watching," the policymaker said.
A senior SEBI official said there were discussions with the central bank, but gave no further details. India is sensitive to 'hot money' flows.
Midway through last year heavy outflows sent the rupee hurtling to record lows amid India's worst market turmoil in more than two decades, but authorities have since brought the country's external imbalances down to more manageable levels.
Market participants anticipate that any potential steps to curb flows into mutual funds would likely involve tightening rules to specify foreign investors can only invest in funds focused on corporate bonds.
The policymaker said the RBI had not reached the point where specific actions were under consideration.
The RBI did not have immediate comment. Foreign investors have bought a net $12.4 billion of government debt so far this year, banking on easing inflation and fiscal reforms by Prime Minister Narendra Modi, who was elected in May by a nation desperate for an economic recovery.
India's debt market is the best performer among major emerging market economies, in sharp contrast to last year.
UBS estimates bonds have provided nominal returns of 12.4 percent so far this fiscal year, their best in 11 years.
"With expectations that both fiscal situation and inflation will get better, confidence among overseas investors is very high," said A. Balasubramanian, CEO of Birla Sun Life Asset Management, which manages 1 trillion rupees.
