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Inclusion of India into foreign bond indices could be a mixed blessing

India is the second largest bond market (at 1.1tn) within emerging markets that’s not covered by global bond indices, but this might change soon as Russia’s recent exclusion paves way for India’s inclusion in global bond indices. India has been working since 2019 to be included in global bond indices as the government borrowings rise and desire to fuel investments requires capital flows. With Covid hitting in 2020 the borrowing rose further and the need for liquidity from external sources gained further traction.

According to the estimates G-sec will have 10% weight in the JP Morgan Government Bond Index-Emerging Markets. Index related inflows are unlikely to be game changer for India immediately but will make foreign participation easier in bond markets. Currently foreign ownership in G-sec is 1.7%. Considering India progresses the way China did with global bond inclusion, this ownership could rise up to 12-15% over the period of time.

Taking a step forward
Markets like India and China are good source of investments for global investors. Therefore, India opening up not only benefits India to diversification but also helps global investors with diversification in their portfolio. India being a country with stable internal factors such as controlled fiscal balance, balanced inflation and most importantly positive growth rate, makes it’s a lucrative investment avenue.

As for India there could be some direct benefits of listing

Improving Market flows
The index inclusion could significantly increase fund flows in bond markets, in return this freeing of the funds allows further diversification of domestic funds in to credit spectrum and towards their traditional loan businesses, the banks’ loans growth. Historically China’s index inclusion resulted in significant inflows. Foreign holdings of China increased from RMB728bn in December 2016 to RMB3.1trn as of August 2022.

Strengthening the currency

As the path opens up for foreign flows, the demand for INR also shoots up. Portfolio inflows could help contain the BoP deficit and improve the outlook on FX reserves to some extent. Recently the Forex reserves have suffered because of the RBI intervention to curb the volatility in currency markets. If inflows stabilise the need for INR spot intervention can reduce.

But there could also be some vulnerable situations

Increased market Volatility
High foreign participation is also associated with higher volatility as more active foreign investors replace more passive domestic investors, such as banks, that tend to hold a large amount of bond investments on their held-to-maturity book. However, we note that there was a sharp rise in local rates on account of tighter global financial conditions and higher US rates. Back in 2013 when the crisis struck foreign ownership of Indian bonds was less than 2%. In time of crisis domestic investor base becomes more crucial and is able to absorb more. The following chart shows the bond benchmark movement during 2013 taper tantrum.

India’s Asset growth

With India’s asset growth being substantial in Insurance as well as wealth management industry. India’s own asset base is becoming wide. The insurance sector owns 26% of the Gsec market and there is likely to be scope for a further increase in ownership, as the insurance sector has been growing at an annual rate of 12% over the past five years. Therefore, India’s growth potential in itself ensures demand for the assets.

Step taken Miles to go

While there could be cheer around the inclusion, it’s a process, there are some hurdles that we have resolved over the past years, but many more needs to be addressed. China opened up in 2016 but it was not till 2021 that it saw a lion share coming into their markets. For India there lies similar challenges.

Reporting Requirements
All bond trades are required to be reported on NDS-OM order matching platform for secondary market trading in Gsecs owned by the Reserve Bank of India and administered by the Clearing Corporation of India Ltd in a two stage process wherein both the seller and buyer of the security have to report their leg of the trade on the same day, and details of the trade from both counterparties need to be matched on the same day including the time of the trade. The requirement to match the trade details on the same day is an operational issue for investors in different time zones.

Taxation Issues
Foreign investors are subject to a 20% withholding tax on coupon payments. There is a capital gains tax of 30% and 10% for holding periods less than and greater than 12 months respectively. One of the issues related to taxation has been that capital gains tax is computed on the dirty price of bond (the cost of a bond that includes accrued interest based on the coupon rate) rather than the clean price, which effectively leads to higher taxes on interest accruals.

Investment Restrictions

Caps on foreign investments has been key obstacle for foreign investors in India. However, it has been addressed by FAR (Fully Accessible Route) for foreign investments in Gsecs in March 2020 under which non-resident investors can freely invest in certain benchmark liquid Gsecs without any quota restrictions on securities. Currently there are 22 securities available under this route.

Depth of the market

RBI has opened up routes for foreign investors but the challenge lies with the market depth. The bond index AUM stands at ~USD 220 bn, India is estimated to be listed at 22bn. The current bond market trade stands at 3.75bn which further gets narrowed at 0.22bn for FAR securities. With thin volumes it is unlikely India can participate immediately for a larger share. The is only if we are to be listed on JP GBI-EM Global Aggregate index which is only $220bn. If we are to be listed on Bloomberg Barclays Global Aggregate Index ($2500 bn), it will further add 7.5-15bn flows in India bond markets. The market activity currently does not support such trade volumes.

It’s a Mixed Bag

Overall, the inclusion of India into foreign bond indices could be a mixed blessing. It will surely help in the near term, lowering our cost of capital, thus providing impetus to capex and manufacturing. Also, opening up capital account can potentially result in better allocation of resources. However, the medium-term impact could be more nuanced, especially when Indian and US business cycles are not well aligned.

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