Tightening Yields, Loosening Inflows: India’s FPI Challenge

SYNOPSIS

Threatening FPI inflows into Indian government debt, the narrowing US-India 10-year bond yield spread - the lowest in 20 years - could result in outflows because of less alluring risk-adjusted returns.

Amid tightening yields and decreasing inflows, India encounters increased challenges in attracting foreign portfolio investments, attributed to the unprecedented narrowing of the US-India bond yield spread.

The Indian debt market is at a prominent position as the difference of the yield between Indian10-year government securities and US 10-year Treasuries shrinks to its narrowest in nearly two about decades. This development is raising concerns as the foreign portfolio investors (FPIs) may begin to exit Indian debt due to diminishing returns relative to the US.

The Fed’s Influence and Soaring US Yields

Reason behind this shrinking spread is the US Federal Reserve’s new policy stance. The Fed has revised its policy for 2025 and scaled back its expected rate cuts to 50 basis points from 100 due to raising its inflation forecast. These moves have pushed US 10-year Treasury yields up to 4.54%. In comparison, India’s 10-year government bonds are currently yielding 6.78%, leaving a spread of just 224 basis points—its lowest since April 2005.

Early Signs of FPI Retreat

This tight spread is already impacting FPI behavior. Data from Clearing Corporation of India Ltd(CCIL) shows that FPIs were net sellers under the Fully Accessible Route (FAR) in October and November. They pulled out ₹5,142 crore and ₹5,187 crore respectively. The month October marked the first net outflow from FAR securities since then April is signaling a possible shift in sentiments.

Domestic Fundamentals Remain Strong

Despite global pressures India’s domestic bond market is still supported by solid fundamentals. Gaura Sen Gupta a Chief Economist of India First Bank said that a favorable supply-demand dynamics which included a controlled fiscal deficit and robust local demand for bonds, These which have kept the yields relatively stable. However, she warns that US yields may keep rising due to the Fed’s aggressive posture and potential fiscal volatility in the US under the upcoming Trump administration.

Why the Yield Spread Matters

Historically, a yield spread of 350–400 basis points has made Indian debt attractive to FPIs, offering compensation for currency and geopolitical risks. “US interest rates were low for over a decade after the 2008 crisis,” a private bank treasury head explains. “Now, with normalization, US yields are catching up.” Madan Sabnavis, Chief Economist at Bank of Baroda, adds that the average spread used to be around 300–350 basis points but has compressed sharply since the Ukraine crisis began in 2022.

Rupee Under Pressure

The tightening spread not only affects FPI flows but also the rupee. Following the Fed’s policy update, the rupee had slipped past the 85-per-dollar mark, reflecting concerns about capital outflows.

Conclusion

As the US continues its hawkish path the Indian yields remain range-bound. The shrinking spread could lead to further FPI outflows increasing the stress on Rupee. Close monitoring and timely policy adjustments are crucial measures to safeguard India’s debt market stability.

Kunwarjeet Singh Rautela