After consultations with the government, the Reserve Bank of India has suggested the cap on foreign institutional investment in government securities be increased from $10 billion to $20 billion.
This would create demand to accommodate extra market borrowing planned for the second half of current financial year.
The cap on FII limit was last raised in September 2010 by $5 billion.
The increased burden on domestic players and rising yields have forced the government's debt manager to change its view on increasing foreign exposure.
Currently, FIIs are allowed to invest up to $10 billion in government bonds, and the limit has been almost exhausted in the first half of 2011-12.
Yields on the 10-year government bond jumped 42 basis points after touching a three-year high since the announcement of the Rs 53,000-crore (Rs 530-billion) extra borrowing in the October-March period.
According to economists, the average cost of government borrowing would rise one per cent for Rs 2.2 lakh crore (Rs 2.2 trillion) envisaged for the second half of FY12.
So, for even a 10-basis point increase in rates, the additional interest cost would be Rs 220 crore (Rs 2.2 billion).
As a result, to cap rising yields devolvement was on primary
However, economists caution against the government's higher exposure to foreign liabilities.
"If the limit is increased, it would likely create enough demand to mop up a significant fraction of the extra borrowing announced for the second half of the year but, by increasing India's external debt, increase vulnerability at the margin," said Sajjid Chinoy, India economist, JP Morgan.
The step would also help offset the drop in fund inflows due to weak performance of domestic equity markets.
"There would be demand for government bonds, as they are offering higher yields compared to developed countries," said a bond dealer with a domestic brokerage.
Market participants feel the government would levy conditions in terms of tenures of dated papers.
"The current limits have been almost utilised. Hence, higher participation from FIIs would be good for markets and would help soothe rising yields.
"But we would have to see whether the enhancement is across the board or it comes with caveats," said a senior official of a primary dealership firm.
When foreign investment limit in corporate bonds was increased by $5 billion this year, it was mandatory to invest the enhanced limit in infrastructure bonds. Currently, FIIs can invest $20 billion in corporate bonds.
