India is expected to become the third largest economy by 2030, surpassing Japan and Germany. It is spending massively on infrastructure development to achieve this target. In the budget for the fiscal year 2023-24, the allocation for capital investment in infrastructure is set to rise by 33%, reaching Rs. 10 lakh crore (US$ 122 billion), equivalent to 3.3% of the GDP¹. Foreign investments will play a key role in making this target sustainable.

A Look Back

India started to make efforts to be included in the global bond indices in 2013 in response to the economic turbulence caused by the announcement of the possibility of quantitative easing by the U.S. Federal Reserve. The ‘taper tantrum’ episode had resulted in large withdrawal of foreign investments from the country, depreciating the Indian Rupee. To control the volatile situation, one of the measures adopted by the RBI was to increase interest rates to encourage foreign investments, resulting in high borrowing cost.

However, until 2020, the Indian Government bond market was dominated by domestic investors (Figure 1). This was primarily due to government-imposed restrictions on the extent of foreign ownership allowed for its domestic debt. Specifically, the government had enforced a 6% cap on foreign ownership of outstanding government securities, along with a limitation restricting total foreign investment in any security to 30% of the outstanding amount². This provided little incentive to foreign investors to include Indian Government bonds in their portfolio. Moreover, foreign investors were unable to monitor the performance of Indian G-Secs because they were not included in any indices. This was a result of India’s inability to meet the stringent criteria set by global bond indices such as the JP Morgan Emerging Markets (EM) Bond Index.

Figure 1: Ownership Pattern of Government of India Dated Securities

Source: Public Debt Management Quarterly Report, Jan-Mar 2022 & Apr-Jun 2023 (Department of Economic Affairs)

Hence, in 2020, when government expenditure soared due to the pandemic and the Indian Government sought ways to source funds and reduce its cost of borrowing, RBI introduced a separate channel, Fully Accessible Route (FAR). FAR made foreign investment in specific bonds possible without any regulatory restrictions. At present, there are 31 securities worth US$ 400 billion that can be traded under FAR.

Current Scenario

The Government of India’s persistent efforts to secure a place in the JP Morgan Emerging Markets Bond Index yielded positive results, with the index providers officially declaring India’s inclusion effective from 28 June, 2024. This inclusion will be phased gradually over a span of 10 months, with an approximate monthly weightage of 1%, culminating in a maximum weightage of 10%. The inclusion reinforces India’s stable economic conditions, also reflected in its consistent BBB-/Baa3 sovereign credit rating by Fitch and Moody’s. “According to the JP Morgan team, almost three-quarters of benchmark investors surveyed were in favour of India’s addition to the index³”.

Upcoming Trajectory

Higher Capital Inflows

The initial expected capital inflow of US$20-30 billion is just the beginning. India’s relatively higher yields compared to other emerging markets in the index could make it an attractive choice for managers seeking to overweight their portfolios (Figure 2). Moreover, JP Morgan’s inclusion has the potential to set a precedent for other emerging market indices, such as the Bloomberg-Barclays Local Currency Government Index and the FTSE Government Bond Index, which could lead to a further increase in portfolio inflows.

Figure 2: Average Yields of BBB+/BBB/BBB- Rated Large EM Markets

Source: Srinivasan, M., & Furey, D. (2023). India Sovereign Bonds: Announcement of Index Inclusion. White Paper, State Street Global Advisors

Stronger Rupee

Higher capital inflows potentially lead to greater demand for the Indian rupee as investors need to convert their foreign currencies into rupees to purchase these bonds. Increased demand for the rupee typically leads to its appreciation. A stronger rupee can also result from improved trade balances. The additional capital can be used to finance trade and current account deficits, reducing the need for rupee depreciation to maintain competitiveness.

A stronger rupee may lead to reduced intervention by India’s central bank to support the currency. When the central bank doesn’t need to continually sell rupees to stabilize its value, it can reduce currency supply, contributing to appreciation. A stronger currency can have positive effects on India’s economic indicators. It can lead to lower inflationary pressures by making imports cheaper, which, in turn, can encourage the central bank to adopt more accommodative monetary policies.

Lower Yields

According to an article by the Bank of Baroda⁴, securities in 5-10 year range are poised to experience the most significant benefits. This is due to the fact that, as of 25 September, 2023, this particular range within the FAR holdings represents the largest share. Consequently, we may observe a downward shift in the entire yield curve within this segment.

Reduced Pressure on Commercial Banks

India’s inclusion in the global bond index is expected to alleviate the burden on commercial banks, which have historically shouldered the majority of government bonds (Figure 1). As foreign investors gain easier access to India’s government bonds, there will likely be a more diversified investor base. This diversification could reduce pressure on domestic banks to absorb government debt, offering them greater flexibility in managing their portfolios and freeing up capital for other lending activities.

Increased Volatility

India’s bond market will become more closely tied to global market sentiment. Any adverse global developments, such as changes in U.S. Federal Reserve policies or geopolitical events, can lead to sudden shifts in investor sentiment, affecting bond prices and yields. Sudden shifts in investor sentiment or changes in global economic conditions can lead to abrupt inflows or outflows of capital, contributing to market volatility. A surge in foreign investment can lead to rupee appreciation, while sudden outflows can result in depreciation. These currency fluctuations can affect the competitiveness of Indian exports and may require intervention from the central bank to stabilize the currency.

Conclusion

India’s inclusion in JP Morgan Emerging Market Bond Index is a positive development and an attestation to India’s stable economic growth. The potential benefits of the inclusion can have a long term impact on the Indian economy. However, the RBI and the government will need to closely monitor market conditions and be prepared to implement measures to ensure stability.

Source:
1. IBEF (May 2023). Advantage India
2. Srinivasan, M., & Furey, D. (2023). India Sovereign Bonds: Announcement of Index Inclusion. White Paper, State Street Global Advisors
3. The Washington Post
4. Mazumdar, D & Gupta, A. (26 September 2023). Impact of India’s inclusion in JP Morgan bond index

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Indian G-Sec were expected to be listed on the JP Morgan GBI-EM (Global Bond Index – Emerging Markets) by 2023. However, according to the latest news, index providers have decided not to include Indian Sovereign bonds in the Index and keep them under review. Concern over Indian market’s lack of adequate trading infrastructure has been cited as the reason behind the decision. Investors were looking forward to India’s inclusion in the Index. The Street view was that the anticipation of India to soon be included in the JP Morgan GBI-EM had put pressure on the yields. It’s a missed watershed moment for the Indian Debt Markets. So, let’s understand what this inclusion could have meant for Indian debt markets?

JP Morgan GBI-EM is one of the major indices for Emerging Markets’ Debt. The Economic Policy Division of the Ministry of External Affairs expected India’s inclusion in the Index would have led to higher capital inflows to the tune of US$ 40 billion initially. These inflows would have helped improve India’s rising balance of payment deficits and in strengthening the rupee.

Higher inflows could also have helped in keeping yields in check. A lower G-Sec yield would have reduced the Government’s cost of borrowing. According to the Union Budget 2022, the Government of India’s cost of debt was Rs. 808101.7 crores. (US$101.37 Billion), which is estimated to rise to Rs. 937437.4 crores (US$117.59 Billion). Further, the Government has an ambitious US$ 130 billion spend plan on infrastructure. So, it is imperative to bring down cost of borrowing.

Downstream effect

Lower G-Sec yields should have also pulled down the corporate bond yields. Corporate bonds typically trade at a premium to G-Sec across maturities (Figure 1). According to RBI, G-Sec curve provides a stable base for pricing of corporate bonds. So, if G-Sec yields reduce, then corporate bond yields should also reduce. And, this should have led to higher issuances and higher liquidity in the Corporate Debt Market.

*1 US$ = Rs. 79.7194. Exchange Rate as on end of August 2022. Source: RBI

Significance of listing

It is not easy to get listed on the GBI-EM Index. There are strict eligibility criteria related to maturity, liquidity, per capita Gross National Income, issue size etc.; that a country has to meet to get listed. Even after meeting these criteria, every country gets an assigned weightage on the Index. This weightage is based on the size of the country’s sovereign debt market. Indian G Sec is a US$ 1 Trillion Sovereign Bond Market. So, if India was included, India’s weightage on the Index was expected to be 10%, which is the maximum weight allocated to a country on the Index.

The weightage of a country in the Index has a significant role in determining the country’s capital inflows. According to an IMF study, a country’s weight in the Index guides the portfolio allocation of benchmark-driven investment across countries in the Index. The same study also concluded that during the COVID-19 pandemic, “portfolio outflows from local currency bond markets were strongly correlated to the weight of the country on the Index”.

However, the weightage of a country in the Index is readjusted based on the country’s performance, economic conditions, and other factors. Russia used to have a 10% weightage on the Index. Post the Ukraine crisis and sanctions, Russia has been removed from the Index. Russia’s exclusion had led to a stronger case for India’s inclusion; to fill the gap.

Further, inclusion in the GBI-EM Index would also have opened doors to inclusion in other Emerging Market indices; Bloomberg-Barclays Local Currency Government Index and FTSE Government Bond Index. All of these would have further enhanced portfolio inflows into Indian Debt Markets.

Hence, in the short run India stood to benefit from the inclusion in the Index. However, whether India would have been able to sustain the momentum in the long run hinged on its economic performance.

This article was originally published in Financial Express.

Link to the article: https://www.financialexpress.com/market/did-indian-debt-markets-miss-a-game-changer-opportunity-again/2758115/

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