Home / Opinion / Views /  Risks that come with India's inclusion in global bond indices

Markets are not known to be strictly rational. Hence, understanding them is an art. Look, for instance, at India’s 10-year G-sec yield. Conventional theories have linked its level with government borrowing, inflation, the repo rate, US Fed rate, US Treasury yields, and so on. But the G-Sec yield has tended to get depressed under the weight of possible good news on Indian bonds being included in global bond indices. What exactly is this about?

Global bond indices include bonds of various emerging markets, and with Russia out due to the Ukraine conflict, there is some hurry in the West for alternatives. India fits the bill, as the size of our G-sec market is around 80 trillion or $1 trillion (state development loans would be around 50 trillion), though not all is traded. The market is relatively liquid, especially benchmark bonds, which are traded in good numbers. If included in global indices, our bonds will see a window open for investment by foreign portfolio investors (FPIs) that were constrained from investing in excluded sovereign paper.

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Contentious issues have been flagged over settlement and taxation. India’s stance is that since these are government bonds, settlements must occur in India. And capital gains be paid as per our rules, as there needs to be a level-playing field for domestic and international players. While these are important, they can be resolved through talks.

There are various estimates of the money that can be attracted—in a range of $20-30 billion annually to begin with, rising to some $50-60 billion in the future. Higher FPI flows into our debt market would mean many things. First, as there is higher demand for government paper, G-sec prices would rise and lower yields. Hence, the government would gain in terms of cheaper borrowings. Second, a collateral benefit will be that corporate bond yields will come down commensurately, as they are benchmarked with G-Secs. Third, more flows into government bonds will mean more liquidity available with banks to lend. (It’s another matter that this has never been a limiting factor, given that banks hold more than their mandatory statutory liquidity ratio). Fourth, inflows will steady the foreign exchange market and thus aid rupee stability, possibly even strengthen it if the flows are high, which would be an enviable dilemma for any central bank. Therefore, the bag of goodies looks attractive to a market that is waiting expectantly for the big inclusion.

The present position of FPIs in the Indian G-sec market is interesting. National Securities Depository Ltd data shows that the outstanding amount in sovereign bonds is around 1.33 trillion, while the foreign portfolio investment limit permitted under Reserve Bank of India (RBI) rules is around 3.75 trillion, which includes 1.22 trillion of long- term debt. So, clearly, today’s open door has not been a major lure, and it can be presumed that if the market is right, the hitch is that our bonds are still not part of global indices. Hence, there is a priori reason to believe that with the right environment, there will be greater FPI inroads into this market. RBI has also expanded the ‘fully accessible route’ for non-residents, which include FPIs, where investments have no ceiling.

The system as it stands today is a purely domestic market monitored closely by RBI and sometimes managed through policy measures. For example, ‘Operation Twist’ helps create liquidity and influence G-sec yields of various maturities. Affirmative statements made via the media can also ‘talk’ yields down or up. These have helped keep things relatively predictable.

But the stock market experience is pertinent here. When there is a global selloff, there are major reverberations in the Indian stock market. The same will hold true for debt. If FPIs are in withdrawal mode in debt markets because interest rates have risen overseas, the quantum of money withdrawn can destabilize our market. Right now, due to low foreign exposure, that does not matter. Further, interpretation of domestic policies will have a bearing on investor moves. For example, a budget can be a turning point for the market if large FPI exposures are involved. In the current situation, a large government borrowing programme does not quite move the needle, and it has been seen that progressively large borrowings by the Centre does not overburden it, cost-wise. But with more FPIs in the game, the rules will change. As a corollary, less aggressive action by RBI compared with, say, the Federal Reserve or the European Central Bank can cause a reversal in flows of investment.

Today, we can brush aside the views of S&P and Moody’s on India’s sovereign debt rating, as they matter little so long as government debt is largely held domestically. With larger FPI flows, possible responses to rating agency calls can be distortionary. The gains being espoused, like a stronger rupee, can become a shock in case of a reversal of flows. This is a cost of global integration that cannot be eschewed. Global integration also requires convergence in economic thought and policy; and governments in a way have to consider the global view. In conclusion, India’s inclusion in global bond indices will be a mixed bag and we should be prepared to align our policies accordingly.

These are the author’s personal views.

Madan Sabnavis is chief economist, Bank of Baroda, and author of ‘Lockdown or Economic Destruction?’.

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