India should be slow to join global bond indices

Fast forward to February 10, 2022 at the Governor’s press conference held immediately after the announcement of the Monetary Policy Committee statement. For the first time, the governor, in response to a question whether the RBI has any objection to the inclusion of G-Secs in the global bond index, acknowledged that inclusion can be a double-edged sword.

For investment banks, especially foreign investment banks, who have been waiting anticipating generous (exorbitant?) management fees and commissions on India’s inclusion in global bond indices, this would have come as a harsh blow.

Ever since Finance Minister Nirmala Sitharaman announced in her February 2020 budget speech that the government is looking to open certain categories of bonds to foreign investors without any limit, the inclusion of government securities in global bond indices has been approved Was asked – a question ‘when’ instead of ‘if’.

After all, the investment banks narrative seemed reassuring enough. Joining global indices will open India’s bond market to more investors and potentially reduce the government’s borrowing costs. Morgan Stanley estimates that India’s inclusion in global bond indices is expected to bring in $250 billion in inflows over the next decade and reduce borrowing costs for the government by 50 basis points.

For a cash-strapped government that faced the daunting task of raising funds to finance a fiscal deficit of over 6% of GDP, the prospect of such an abundant influx of potentially hot money It was tempting enough to blind it, perhaps, the downside of such flow.

A negative aspect that eventually manifested itself in the Governor’s statement at the post-policy press conference. The truth is that the potential long-term cost of attracting hot money flows must be weighed against the short-term benefit of attracting large inflows. There is no doubt that foreign investors will come. RBI’s response to the Fully Accessible Route (FAR), under which foreign portfolio investors (FPIs) can buy government securities without any limit, is proof of their interest. by the sum of 1.50 trillion offered by RBI under the Voluntary Retention Route (VRR) as part of FAR, amounting to 1,49,995 crore was availed till 10 February 2022. (limit has now been increased) 2.50 trillion).

Publicly, what is preventing inclusion is the issue of exemptions from capital gains taxes that non-resident investors are seeking (this would disturb the principle of parity with domestic investors). The widely accepted notion is that once this is resolved and negotiations with Euroclear for settlement of Indian bonds are completed, inclusion will follow.

However, Governor Das’s confession is the first indication that a lot is at stake. Inclusion in the global bond index will expose us to all the risks of passive index-based investing, in that any change – even external ones – will subject us to wildly fluctuating flows. For example, after the publication of a record high US inflation (7.5%) in January, global markets saw massive bond selloffs on Friday, 11 February 2022. The consequent outflow of funds from all emerging markets (including India) impacted our forex market, with the rupee crossing 75 for the dollar. But the bond market was not affected. The yield on the benchmark 10-year government securities closed at 6.7%, hardly lower than the previous day’s closing level. Had India been a part of the global index, the story would have been completely different. There would have been havoc in both the bond and forex markets.

Beyond that, the question is, what do we do with such inflows? Do we have enough bankable/viable projects where we can deploy these funds? What about the effects of our exchange rate? Do we want Rupee to increase/present our exports uncompetitively? Sure, the RBI can add to its growing reserves, but what happens to the liquidity (and inflation) of the rupee when it pumps in rupees against dollars?

All of these need careful consideration before we get carried away and make easy choices. Inclusion in global bond indices may give us a higher sugar, but like all such highs, there is a downside. Our macro fundamentals should be strong enough to move higher with the lows. We are not there yet.

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