India in the Global Bond Index: What Next?

 

At last, India has made its entry into JP Morgan’s global bond market index. This will of course happen over a period of 10 months, starting from June 28, 2024, with a weight that is expected to reach 10% at an incremental of 1% per month by March 2025 in the GBI-Em Global Diversified Index. That aside, India is also likely to be included in other indices under the GBI-EM suite, with total assets of $236 bn under its management. 

With Russia out of the index after being ostracized post-Ukraine invasion, there emerged a free slot for another country to fill it and India with a fully accessible route for investment in the Government Securities (G-Secs) market that offers 23 government bonds with a notional value of Rs. 27 lakh cr equivalent to $330 bn, fit the bill quite well. 

Obviously, when G-Secs are included in a global index, the Indian bond market is certain to get a fillip, for foreign funds are likely to invest in G-Secs in larger quantities than what they are currently doing. The very inclusion in the global index affords a kind of gold standard to our bonds due to which foreign funds will be encouraged to invest. Even through passive investments of fund houses in a bond index, we are likely to get about $20-30 bn by way of our share of 10% in the index. In addition to that we may also get additional inflows by way of direct investment in our bonds as they offer higher interest vis-à-vis global rates. All this cumulatively leads to an increase in foreign portfolio investment (FPIs) in the debt market. 

One may now pose a question: Isn’t this happening today? True, FPIs do invest in G-Secs, but the limits prescribed for FPIs are not being fully utilized. The debt utilization statistics reveal that FPI holdings in G-Secs stood at 23.51% for general foreign investors and for long-term foreign investors it was about 5.59%. 

In such a scenario, the inclusion of our bonds in the index will be a game-changer: it is certain to widen our investor base, besides bringing down the cost of capital. Secondly, at a later stage, lured by the favorable yield on these indices, investors may even show security-specific interest, which means a still wider investor base.  Thirdly, it may even lead to the inclusion of corporate bonds at an opportune time. Finally, all this results in large capital inflows, which means not only a stronger rupee but also a strong surplus balance of payments position despite a widening current account deficit. 

Over and above all this, funding of the government deficit by FPIs, eases pressure on domestic banks for funds. This in turn will pave the way for banks to allocate more resources for lending to the private sector, resulting in economic expansion. 

However, there is a flip-side to this hunky-dory scenario. The inclusion of Indian bonds in the global indices exposes our bond markets to the repercussions due to exogenous forces. For instance, a phenomenon like the 2008 Global Financial Crisis would lead to a sell-off across markets and once our bonds are a part of the indices, it would result in capital flight. Such capital flight can destabilize not only the bond market but also exchange rates. In such situations, the intervention of Reserve Bank of India (RBI) assumes paramount importance in stabilizing both the forex and bond markets.  

At times, FPIs can induce volatility in domestic markets through their responses to exogenous reasons. For instance, when the US Federal Reserve raises interest rates dollar gets strengthened automatically, and this would simply trigger capital flight. This creates volatility in the forex market calling for RBI intervention. Such outflows create a cost for the central bank. Similarly, country rating plays an important role in the trading patterns of fund managers. Any change in rating outlook can also affect the investment patterns of funds, which can cause volatility. 

Today, RBI is in a position to successfully regulate excess volatility in the bond market by affecting liquidity. Thus, it has all the while managed to keep yields from G-Secs range-bound. This has helped the government in keeping its cost of borrowing moderate and stable. But once the FPIs start playing actively in the G-Secs market, the scene will change. Similarly, high foreign holding of debt exposes our markets not only to external macroeconomic shocks but also to geo-political risks. That aside, it subjects our fiscal situation to greater scrutiny. To sum up, on the positive, there will be an influx of foreign funds but the market and the RBI must be ready to manage external shocks and volatility with alacrity.