The possibility of inclusion of Indian bonds in global bond indexes has been a possibility for some time and has now become a reality. JPMorgan Chase announced that starting from June 2024, it will include 23 Indian bonds with a nominal value of US$330 billion. This ratio will rise to 10% over 10 months, with monthly increments of 1%. Since Russia was excluded from the index after being ostracized after its invasion of Ukraine, another country has a place, and India fits the bill perfectly. What are the advantages and disadvantages of this development?
Essentially, when Indian bonds, known as government securities (G-Secs), are included in global indices, the Indian bond market will get a boost as foreign funds will buy more G-Secs than they do now. Some funds have the right to trade bonds in global bond indices. So the inclusion of bonds became something of a gold standard because it was recognized globally.
The way it works is this. Funds dealing with the index will arbitrage between the index (which has Indian bonds as a component) and between the components and the index. When people passively invest in bond indexes, funds will automatically be allocated to Indian bonds, and Indian bonds will bring in foreign exchange inflows. For example, if a fund invests $1 billion in a global bond index, it will automatically be allocated proportionally to the various components of the index. This will automatically lead to an increase in FPI in the debt market. But doesn’t that happen today?
Yes, FPIs do invest in government debt as per prescribed limits. But they don’t use the full amount because these are exogenous decisions. Currently, FPI uses about 19% of the total limit provided. Being part of a global index will increase interest. This is the good part of the story as one can expect more FPIs to come in as these funds handle billions of dollars in investments. We may see additional inflows over the next few years that could even reach $330 billion. The same effect may occur when other indices include Indian bonds.
The Reserve Bank of India has given more scope for investment without restrictions on certain securities. In fact, once included in the index, corporate bonds may also be included in the index in due course. But to start this chain, it is important to enter the market.
Are there any disadvantages? Here it is necessary to add some considerations that need to be understood when including Indian bonds in a bond index. Once any decision is linked to the global market, it cannot escape the influence of any external force.
First, a Lehman Brothers-like crisis would lead to a market-wide sell-off, leading to capital flight once Indian bonds become part of these indices. In 2008, India was completely unaffected by the entire incident due to its inherent decoupling from global markets. While the stock market was affected, the bond market was relatively unaffected. This will not be the case once large investors invest in domestic bonds.
Second, domestic policies are always closely watched as part of the index. For example, today, since all Indian debt is denominated in rupees, it doesn’t really impact global traders. But once it is part of the index, higher fiscal deficits (e.g. requiring more borrowing) will lead to volatility in the global index, which will also affect Indian markets.
This can also be seen in the stock market when certain policy decisions are taken and investors may have different views. In this sense, RBI’s intervention is crucial to stabilize the foreign exchange and bond markets.
Third, sometimes due to external reasons, FPI actions may trigger market fluctuations. For example, when Western central banks implemented quantitative tightening, the pool of investable funds available to invest in emerging markets was relatively small. This means there will be disinvestment in emerging countries, as seen in the stock market.
Looking at it from another level, the main factor leading to the depreciation of the rupee in 2022-23 is the external factor of the strengthening of the US dollar in global markets due to the Fed’s interest rate hike; this triggered a return of capital to the US. Dollar outflows due to FPI exiting the market will require more RBI intervention in the foreign exchange market. Therefore, when dollars flow out, the benefits of dollar inflows become costs.
Fourth, country ratings are not currently important to the market, but may have collateral effects on fund managers’ positions and trading patterns. India has been advocating for a higher rating, but this has not materialized. Any changes in ratings or outlook can affect the fund’s investment pattern, resulting in volatility.
Fifth, the RBI can currently successfully regulate excessive volatility in the bond market by affecting liquidity. Yields have been observed to be range-bound most of the time, which also helps the government keep borrowing costs moderate and stable. One reason is that external shocks have less impact on bond yields in domestic markets. But once the G-Sec market sees more FPI activity, the situation will change. For example, when funds enter selling mode, implementing the ICRR (Incremental Cash Reserve Ratio) could cause yields to spike, putting more pressure on monetary authorities.
Therefore, the inclusion of Indian bonds in global indices is an interesting development. The economy has been one of the best performing over the past few years. The positive side is that there will definitely be an influx of money depending on the space allowed. Once in, markets must prepare for greater volatility; central banks must ensure stability in bond and foreign exchange markets.
The author is chief economist at Bank of Baroda.Views are purely personal