The inclusion of Indian bonds in global bond indices, which has been on the cards for some time, is a reality now. JP Morgan has announced that 23 Indian bonds will be included with a notional value of $330 billion from June 2024. The share will rise to up to 10 per cent in 10 months at an incremental rate of 1 per cent per month. With Russia out of the index after being ostracised post the invasion of Ukraine, there was place for another country and India fit the bill quite well. What are the pros and cons of this development?
Essentially when Indian bonds, which would be government securities (G-Secs), are included in a global index, the Indian bond market will get a fillip as foreign funds would buy G-Secs in larger quantities than they are doing today. Several funds have mandates to trade in bonds that are part of global bond indices. Hence having the bonds included becomes some sort of gold standard as there is global recognition of the same.
The way it works is like this. A fund which deals with the index would take positions in both the index, which will have Indian bonds as a component, as well as arbitrage between the components and the index. When one invests passively in a bond index, funds would automatically be allocated to Indian bonds which will see forex inflows. For example, if a fund invests $1 billion in a global bond index, it would be automatically allocated across the components of the index in a proportionate manner. This will automatically lead to an increase in FPIs in the debt market. But doesn’t this happen today?
Yes, FPIs do invest in government debt based on the limits that are prescribed. But they have not utilised the full amount as these are exogenous decisions. Presently, around 19 per cent of the total limit offered is utilised by FPIs. Being part of global indices will add buoyancy to the interest. This is the good part of the story as one can expect more FPI to come in as these funds deal with billions of dollars of investment. We may see additional flows which could even go up to $330 billion over the next few years. Other indices could have the same effect when they include Indian bonds.
The RBI has already given more space to invest, with there being no limits for certain specified securities. In fact, once included in the index, at a later stage, there is also the possibility of corporate bonds getting included at an opportune time. But making an entry is important for this chain to be set in motion.
Are there any cons? Here it is necessary to add several caveats that need to be understood when Indian bonds are included in the bond indices. Once any decision gets linked to the global markets, there can be no let off from any repercussions due to exogenous forces.
First, a Lehman-like crisis would lead to sell-off across markets and once Indian bonds are part of these indices, there would be capital flight. In 2008, India was quite insulated from the entire episode due to the inherent decoupling across Indian and global markets. While the reverberations were felt in the stock market, bonds were relatively insulated. This will not be the case once large investors invest in domestic bonds.
Second, domestic policies always get closely tracked when part of an index. For example, today as all Indian debt is denominated in rupees, it does not really affect global traders. But once a part of the index, a higher fiscal deficit for example which entails more borrowing, will cause volatility in the global index which gets translated into Indian markets too.
This has been seen in the equity market too when there are certain policy decisions taken which may be perceived differently by the investors. To this extent the intervention by the RBI will be paramount to stabilise both the forex and the bond market.
Third, at times volatility can be induced in the market by FPI behaviour due to exogenous reasons. For example, when the Western central banks went in for quantitative tightening, relatively smaller pools of investable funds were available for investing in emerging markets. This meant there would be a withdrawal from emerging countries just like what was witnessed in the equity market.
At another level it was observed in 2022-23 that the main factor that caused the rupee to depreciate was the external factor of dollar strengthening in the global market due to the Fed increasing rates; this triggered flight of capital back to the US. Any outflow of dollars due to FPIs withdrawing from the market will require more intervention in the forex market by the RBI. Hence, the benefit derived from getting in the dollars will become a cost when there is an outflow.
Fourth, the country rating, which today is not really important for the market, can have collateral effects on positions taken by fund managers as well as trading patterns. India has been right in arguing for a higher rating which is not materialising. Any change in rating or outlook can affect investment patterns of funds, which can cause volatility.
Fifth, presently, the RBI can successfully regulate excess volatility in the bond market by affecting liquidity. It has been observed that the yields are range bound most of the time and this also helps the government in keeping cost of borrowing moderate and stable. One of the factors for this is that there is less scope for external shocks to affect the bond yields in domestic markets. But once there is more FPI activity in the G-Sec market, the picture will change. For example, the imposition of ICRR (incremental cash reserve ratio) can spike up yields as funds get into a sell mode, thus putting more pressure on the monetary authority.
Hence the inclusion of Indian bonds in global indices is an interesting development. The economy is one of the best performing one in the last few years. The positive is that there will most certainly be an influx of funds depending on the space permitted. Once in, the market has to be prepared for more volatility; and the central bank has to ensure that there is stability in both the bond and forex markets.
The writer is Chief Economist, Bank of Baroda. Views are personal