Bond inflows: Get ready for a trilemma re-tweak

It is fair to assume robust foreign demand for top-quality Indian debt.
It is fair to assume robust foreign demand for top-quality Indian debt.


Greater globalization implied by Indian G-Sec inclusion in a JPMorgan index will attract a capital bulge and weaken RBI’s rIin on inflation unless we let the rupee float more freely

India’s answer to the Impossible Trinity constitutes a peculiarly fine balance. In theory, we cannot have capital flowing freely in and out, control of the rupee’s exchange rate, and also full autonomy over monetary policy. It’s an economic trilemma. In practice, our post-1991 reform transition spelt a mix of slowly easing capital controls, a decreasingly managed float for the currency, and a central bank increasingly empowered to keep a lid on inflation. Flows from overseas into Indian assets have starred in this story of our calibrated embrace of global capital. News that JPMorgan Chase will include a clutch of government bonds in a key suite of its Government Bond Index for Emerging Markets (GBI-EM) starting in mid-2024, with their weightage likely to rise over 10 months to 10% (a la China), signals the opening of another sluice gate. As with other such indices (like Bloomberg Barclays and FTSE Russell), the GBI-EM guides the allocatory calls of major institutional investors that invest in sovereign debt. By most estimates, next year’s inclusion will draw at least an annual $20 billion extra into government paper. With domestic savings in a slump, exports flagging and import bills looking heavy, that’s clearly good news. We need all the inflows we can get.

Broadly speaking, it is fair to assume robust foreign demand for top-quality Indian debt. On a macro reckoner of the sort employed by credit rating agencies, the state can reasonably be trusted to honour its obligations, India’s external exposure remains moderate, and it’s policy caution that had placed limits on sovereign bonds held in foreign hands. In 2020, access was thrown open to a big chunk of government securities via the Fully Accessible Route (FAR). Enlarged demand for FAR G-Secs (said to make up more than a quarter of all outstanding), some of it in anticipation of GBI-EM-guided buying, will help compress the government’s cost of funds to the extent it softens bond yields. Over time, it should cheapen capital for private bond issuers as well. Moreover, capital inflows will shore up the rupee too. In this frame of analysis, thankful is all we need to be. If an eyelid is to be bat, it’s over the added discipline our finances would be subject to once global portfolios are stuffed with Indian paper. The Centre would have to credibly abide by its fiscal glide path (rather relaxed though it already is), even as the Reserve Bank of India tightens up on inflation control for the sake of basic currency stability. Else, G-Secs could get too volatile for comfort.

We will need to be careful on other fronts as well. The post-inclusion dynamics of the G-Sec market will also go by the yield premium these bonds offer over US Treasury bills. Right now, this spread is extraordinarily small, thanks to the US Fed’s dramatic effort to quell inflation; and further Fed action might soon squeeze it further. But the effect of a relative-returns shift is far more visible on foreign holdings of Indian equity: As the earnings yield of the BSE Sensex dropped below the yield of 10-year US Treasury bills last week, foreign money began to leave, snapping a six-month run of net inflows. After mid-2024, flow reversals will start playing out starkly on G-Secs too. Should overall inflows of capital bulge, as expected, the trilemma will also get amplified. Since dollar-buying by RBI to ‘manage’ the rupee’s rise would weaken its rein on the domestic cost-of-living, require larger liquidity soak-ups and imply dearer debt, it would be best to let the currency float more freely for monetary policy to retain efficacy. Let’s favour its internal stability over external.

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