Each September, the bond market awaits the announcement of India's inclusion in global bond indices. Much ink (mostly digital these days) gets spilled on the likely impact of inclusion. Like the characters in Samuel Beckett's (Irish novelist and dramatist) play, each year we have heard the news that inclusion is not coming this year. Well, Godot has arrived.
JP Morgan has announced that Indian G-Secs will form part of its global emerging market bond indices (GBI-EM Global index suite). Historically, the participation of foreign investors in the Indian markets has been tepid and virtually non-existent. The suggested inclusion could drive US$25 - 30 billion (Rs 2.5 lakh crore) over the next 18 months. Markets have been a buzz on possible inclusions, the confirmation saw markets react positively across the yield curve with long bonds seeing heightened trading activity. The benchmark 10-year G-Sec stood at 7.10% at the time of writing this note.
Now what?
The initial reaction was the obvious one: the market rallied (yields dropped) on open by about 8 bps. In the hours since, most of that opening gain has been given away. The reason being that this was largely anticipated. While this index inclusion news is good, we need to temper our expectations and look beyond the initial reaction to see the impact over a period of time.
This year the government expects to issue about Rs 15.4 trillion debt. The market expects a slightly larger number next year. During FY25, we should see inflows of about $20-25 billion from funds benchmarked to the JPM indices. That is about Rs 2 trillion. That represents about 12% of the gross issuance of one year. While this will certainly reduce the pressure on the market to absorb the supply, we need to be realistic about the impact.
We also need to recognize that the RBI may well abstain from open market operations if there is such a large inflow next year. The net liquidity needs of the banking system is of the order of Rs 2.5 to 3 trillion each year. This is met through any balance of payments surpluses or through G-Sec purchases by the RBI. If this liquidity need is met by foreign demand for G-Secs, the RBI will not need to support the market through OMO.
Those are the words of caution, now for some optimism.
The initial estimate of inflows of up to $25 billion is based on the size of funds benchmarked to the JPM indices. Two things could lead to that estimate being very conservative:
First, that several investors who may not be directly benchmarked to these indices may well follow the benchmark and invest in India. Inclusion in the GEMB indices is a vote of confidence in the market and could lead to a greater level of interest in Indian bonds among global asset owners.
Second, this could presage inclusion of Indian bonds in other major indices in the future. A positive initial experience of investors could go a long way to making this happen. This could result in a sustainable medium-term flow into our markets. The spillover effects of Indian bond inclusion in global indices also need to be taken into account. There will be additional scrutiny of Indian macro and finances by global analysts, especially on a comparative basis. There will be pressure on the government to continue to pursue fiscal prudence.
Indian G-Secs will also be included in the GBI-EM GD IG index of Investment Grade emerging market bonds. As the country rating is BBB-, there will be some pressure to ensure that we maintain and improve that rating and not allow it to slip into speculative grade. India is a bit of an outlier among investment grade countries in terms of per capita income, fiscal deficit and inflation. We are supported by low external foreign currency debt and high growth. We will need to maintain and improve on the macro and financial fundamentals on a sustained basis.
On balance, we should expect the impact of this news of inclusion in EM indices to be broadly positive.
Over the medium to long term, we can also hope for some changes to the overall external sector approach to policymaking. India's international investment position (assets and liabilities in foreign countries) is lop-sided. For the medium term, once this entire noise around Fed hikes and global yields stabilizes, we believe peak market rates are behind us and market yields could gradually soften. From a demand perspective, markets could see incremental buying from active foreign funds. That would probably be less than $ 5 billion before the index inclusion.
Most of India's assets are in the form of reserves. These are relatively low yielding bonds like US treasuries. However, a large part of our liabilities is in the nature of equity. Thus, foreign investors have earned higher returns on their investments in India than we have on our investments overseas. As some liabilities shift to bonds, this should redress this imbalance a little.
India has taken an asymmetric approach to foreign investment. While we openly allow foreign investors to invest here (both in equities and through the FAR route in g-secs without limit) we have placed significant hurdles in outbound investments by Indian investors. Hopefully the closer integration of our markets with the rest of the world will lead to a more liberal approach to investments.
10 Years to the day, India suffered one of its worst balance of payments crises leading to a sharp deterioration in its currency and labelled as a 'Fragile Five' nation. Fast forward to 2023, a series of gradual policy reforms have allowed India to expand its global clout in the world of market finance and further integrate into the global financial system. The announcement today by JP Morgan to include select Indian government securities into its emerging market indices is a 'material' event for the Indian bond markets.
Maybe the dream of capital account liberalization can be achieved after all. That is a Godot we have been waiting far longer for.
(R Sivakumar is Head of Fixed Income at Axis Mutual Fund)
Disclaimer: These are the personal opinions of the author
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