Indian capital controls are proving deeply insufficient as overseas investors continue to snap up corporate bonds in the country. That exuberant demand is undermining the government's attempts at financial stability.
India currently caps total foreign investments into corporate bonds at 2.44 trillion Indian rupees ($38.1 billion). When overseas buying crossed 92 percent of that quota in July, the government suspended the issuance of offshore rupee-denominated bonds until foreign holding falls back below that level.
Instead of slowing down, buying enthusiasm gained more momentum: foreign ownership of Indian corporate bonds pushed past 96 percent of the allowed cap and has stayed above 99 percent for most of the last one month, according to data by the country's National Securities Depository Limited.
Data source: National Securities Depository Limited
And there are no signs of stopping, given how bonds from Asia's third-largest economy provide some of the highest returns in today's investment climate, fund managers said.
"Yes, there is still a case for adding Indian bonds," Wontae Kim, research analyst at Western Asset Management, told CNBC in an email. "India offers a mix of relatively high yields, a firm political mandate, improving fundamentals and FX stability that few markets can."
The average fixed coupon rate of Indian corporate debt issued from January to July 2017 is at 7.27 percent, according to data provided by Dealogic. That is lower than Indonesia's 9.16 percent, but it exceeds other emerging markets such as Mexico, Brazil and Malaysia.
That hunt for yield have led to net foreign investment inflows of 1.13 trillion rupees ($17.65 billion) into the Indian debt space from January to July 2017, compared with a net outflow of 47.24 billion rupees a year ago, data by India's National Securities Depository Limited showed.
Coupled with an increase also seen in the equity markets, the surge in total capital inflows into India sent the rupee appreciating by 5.8 percent in the first seven months of the year and is complicating the Reserve Bank of India's task of managing its monetary policy, analysts said.
The central bank has chosen to intervene in the currency markets to ensure that the rupee does not rise to an unsustainable level. As it has sold rupees in exchange for U.S. dollars, India's foreign reserves hit an all-time high of $393 billion in August.
"Rising reserves build a buffer against external volatility ... However, a downside of this build-up is the associated costs and weak returns in the midst of soft global yields," DBS economist Radhika Rao wrote in a Tuesday note.
The continued climb in foreign inflows into India also left investors wondering whether the central bank has other tricks up its sleeve as it maintains economic progress in a country that is also battling softer-than-expected inflation and rising levels of bad debt in the banking system.
"In the context of managing this challenge, investors have asked if the RBI will cut policy rates and lower real rates to prevent further currency appreciation. But we think this is unlikely," Morgan Stanley analysts wrote in a note.
"RBI monetary policy will only take into account the impact of currency appreciation on inflation into its policy decision, rather than tackling currency appreciation per se ... (But) as the excess liquidity challenge looks set to persist, the RBI will need more tools," they added.