Bond index inclusion a vote of confidence in India’s economic stability

The addition of Indian bonds in JPMorgan’s Emerging Markets Bond indices is testament to investors’ confidence in the country’s fiscal discipline and macroeconomic stability. That it has come about while access to the Euroclear settlement system is still pending and with almost no concessions on withholding and capital gains taxes is noteworthy.

India will be included in at least one of the JPMorgan Emerging Markets bond indices (and significantly in their JESG variants), the GBI-EM Global Diversified Index suite, beginning 28 June 2024, and thereafter reach 10% of the index weight in a staggered manner over 10 months.

The JPM bond index is one of the three larger global bond indices. The others are the FTSE Russell and Bloomberg Barclays indices.

Given the attractiveness of India’s sovereign bond market (in terms of relatively high yields and a stable exchange rate), it is likely that these indices will also eventually consider including India in their respective indices, if capital account controls are further eased.

A de facto partial easing of capital controls began when the Voluntary Retention Route (VRR) was introduced for foreign portfolio investors in 2019. It gave them more choices of investment instruments and exemptions from some regulatory norms. The scope was then significantly expanded with the introduction of the Fully Accessible Route (FAR) series of bonds in April 2020, which allowed non-residents to invest in specified Government of India securities (G-Secs) without being subject to any investment ceilings.

Twenty-three Indian government bonds (IGBs) with a combined notional value of $330 billion ( ₹27.37 trillion) are eligible for inclusion in the JPMorgan indices. The total notional value outstanding of IGBs is over ₹96 trillion. Of this, the FAR bonds have a notional outstanding of ₹27 trillion. FPIs’ exposure in the FAR bonds is reportedly about ₹95,000 crore.

Details are still awaited, but the following are some potential implications.

It is estimated that investors in the JPM GBI-EM Index have $236 billion invested in the index bonds. Accounting for the assets under management of the various sub-indices, IGB bond buys by FPIs might be in the range of $20-23 billion. Inclusion in associated indices will add to this. These are passive flows which are allocated from investors’ portfolios to the index weight.

In addition, there are likely to be significant active funds flows, where other investors, in anticipation of a drop in bond yields given the additional expected demand from index investors, might take long positions in some of these securities. We are therefore likely to see an even larger balance of payments surplus in FY24 than our earlier anticipation of $17 billion. Consequently, even in the run-up to the start of the index inclusion, we will probably see a gradual and continuing drop in yields of the bonds included in the FAR list.

Note that we expect the Reserve Bank of India’s (RBI) monetary policy committee to begin cutting the repo rate in the second half of FY25, reinforcing the effects on yields of additional demand.

Depending on the magnitudes of these inflows, if the RBI were to intervene in the spot foreign exchange markets to manage volatility in the event of a sharp appreciation of the Indian rupee, there will be a large increase in domestic system liquidity.

Assuming an inflow of around $40 billion via portfolio investments in bonds over the course of the next couple of years, and assuming a clean spot buy by the RBI without swapping into forwards of half the amount, would add around ₹1.7 trillion to system liquidity. This will necessitate some sterilization. While open market operation securities will absorb part of this, an increase in the cash reserve ratio will probably be required.

Over and above this, a fall in yields, being a growth driver and other things being equal, is also likely to increase portfolio flows into equities, thus boosting the stock markets as well.

Saugata Bhattacharya is executive vice-president at Axis Bank. Views are personal.