India’s Integration With Global Bond Markets: A Tale Of Two Ideas

In July 2019, when Nirmala Sitharaman presented the first budget of the Narendra Modi government’s second term, one of the big ideas pitched was that the Indian sovereign would issue a foreign currency denominated bond.

India had stayed away from foreign currency sovereign borrowings – a decision long-considered prudent. But the government thought the time was right to shed some of that caution and announced its intention to borrow overseas. “The Government would start raising a part of its gross borrowing programme in external markets in external currencies. This will also have beneficial impact on demand situation for the government securities in domestic market,” Sitharaman said as part of her maiden budget speech.

A vigorous debate followed. The proponents said that India needs to tap foreign financial savings as the domestic pool is exhausted by public sector borrowings; critics said it opens up the economy to unnecessary vulnerabilities.

For now, those advising caution appear to have prevailed. After a few initial rounds of discussions, there have been few reports of progress on any such possible issuance.

However, it appears the current administration has not given up on the idea of deeper integration of India into the global debt markets. It now hopes to push for India’s inclusion in a global bond market index and an intention to this effect may find its way into the upcoming budget.

Global Bond Index Inclusion: What It Will Take?

In order to facilitate India’s inclusion into global bond indices, the limit for foreign investment in Indian government bonds may be raised to 10 percent of the outstanding stock compared to 6 percent now, Business Standard reported in December.

A sharp increase in the foreign investment limit in government bonds would be a departure from the approach followed by the central bank so far, which is to gradually increase the extent to which foreign investors can hold local currency debt. This calibrated increase was seen as a way to avoid a sudden increase in volatility in the rates market.

The increase in limits, if announced, would also come at a time when even existing limits have not been fully used up. For instance, about 25 percent of the foreign investment limit in central government bonds for the ‘general investor’ category is currently unused. Nearly 70 percent of the separate limit for ‘long term investors’ remains unused. Under a new window called the ‘Voluntary Retention Route’, about 24 percent of the limit remains available.

As such, a hike in foreign investment limits in the debt markets, if approved, would be done purely with an eye on inclusion in the global bond indices.

The increase in limits may be necessary but not sufficient. An inclusion in global bond indices may dictate a whole bunch of other changes. For instance, India has from time to time imposed limits on foreign investment in shorter-tenor bonds. It has also used restrictions on minimum residual maturity of bonds as a way to curb speculation.

These micro-regulations may need to go along with an increase in the overall foreign investor limits if India hopes to find a place in these indices.

The Pros And Cons

So is it worth the effort?

The argument in favour of going the distance to land a spot in one of these indices is that you draw in a different pool of foreign capital. This is money benchmarked to global bond indices, which mostly bypasses India.

Of the three main indices, the Bloomberg-Barclays Emerging Market Bond Index has the largest amount of money tagged to it, estimated at about $2 trillion. The other two indices are the FTSE Russell Government World Government Bond Index and the JPMorgan Government Bond Index-Emerging Markets.

Depending on which index India targets and the weightage Indian bonds get, bankers expect that a pool of close to $15-20 billion will become eligible to flow into India. This would be ‘non-discretionary’ money that would flow in in-line with the allocation to the wider emerging market universe.

The share of such benchmark-driven funds has been rising.

According to the IMF’s April 2019 World Economic Outlook report, the amount of funds benchmarked against widely followed emerging market bond indices has quadrupled in the past 10 years to $800 billion. Citing a 2017 study, the IMF said that nearly 70 percent of country allocations of investment funds are influenced by benchmark indices.

But the increase in benchmark-linked bonds flows, however, is a double-edged sword, the IMF cautioned.

“On the upside, inclusion in major benchmark indices provides countries with access to a larger and more diverse pool of external financing. On the downside, benchmark-driven flows to emerging markets can be highly sensitive to global factors and, more generally, to factors common to emerging markets included in benchmark indices,” the IMF said. It added that a larger share of benchmark-driven investments in total portfolio flows could increase volatility of flows and have, in some cases, destabilising effect.

To be sure, even at 10 percent, India’s foreign investment cap in government debt would still be lower than competing emerging markets. For instance, 40 percent of Indonesia’s government bonds are held by foreigners.

Still, any commitment to keep easing up these limits as a pre-condition to finding a place on the global bond indices must be approached with India’s customary caution on foreign debt flows.

Ira Dugal is Editor - Banking, Finance & Economy at BloombergQuint.