Is the selling by FPIs in bonds also driven by Moody’s recently downgrading India?

The actual reason for FPI selling in debt is the negative real rates that FPIs are earning in India. No investor wants to put money when the real rate is negative and today India real rates are lower than developed countries. That does not make sense. But there are two more factors. One, as you said, is sovereign ratings and the other is rupee value.

Moody’s recently downgraded India’s sovereign debt to Baa3 in Jun-20. It had also lowered the outlook for the Indian economy to unstable. This is the lowest rating in the investment grade and any downgrade from here will push India into speculative category alongside Russia and Nigeria. That means a sharp fall in bond prices and spike in bond yields.

Obviously, FPIs fear that such a move would result in huge losses on their debt portfolio. Here is why FPIs expect a rating downgrade in India by next year. Fiscal deficit looks all set to cross 8% in FY21 as the government needs to spend a lot more to boost the economy. Hence, these FIIs see a distinct possibility that India could see another downgrade.

Of course, there is the rupee weakness issue too. A 5% weakness in the rupee can almost wipe out bond returns. In the last one year, INR is down 8% making it one of the worst performing EM currencies. It is an amalgam of weak rupee and the risk that the Indian banks could become unstable if NPAs rise. That is really keeping FIIs wary of investing in Indian debt.