Soumya Kanti Ghosh: Is India ready to enter global bond indices?

Macro-fundamentals suggest not, nor does the level of retail participation in the debt market

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Even though we may have won the battle with the current account deficit, there is palpable excitement around the possibility of India's inclusion in a global sovereign bond index. In a post-conference policy call, the Reserve Bank of India set the cat among the pigeons by highlighting the costs that are typically associated with such an entry.

The basic premise is that India's inclusion in a global bond index will facilitate more stable investment flows from pension funds and life insurances. However, the primary precondition to joining any global bond index includes removing all the caps on foreign institutional investor (FII) investments in debt. This is tantamount to making the rupee fully convertible on the capital account. This proposal raises other important questions such as:

• do current macro fundamentals support such a measure?
• how will foreign participation lead to the development of debt markets in India?
• why is there a sudden shift in FII preference for debt when equity is known to yield higher returns than bonds?

First let's look at the progress made on signposts suggested by the S S Tarapore Committee for capital account convertibility (CAC). As the table shows, none of the signposts are encouraging.

Further, should debt be liberalised under the compulsions of balance of payments? Probably not, because FII investment in domestic debt may be rupee-denominated but it creates an indirect claim on foreign exchange reserves as well. The recent experience with respect to the possibility of a reversal of quantitative easing (QE) shows how higher FII participation has induced volatility in the debt segment that spilled over into the exchange rate market.

FII participation is welcome because it will increase the number of players and add liquidity to the market, but there is a counterpoint. There should be an institutional mechanism, so that higher FII participation and retail participation move together. Interestingly, the effective equity exposure of households in total savings declined to 3.1 per cent in FY13 from 10.2 per cent in FY93. Indeed, the CAC committee had observed: "To improve depth and liquidity of the G-Sec market, particularly in an environment of freer capital flows, as well as to improve price discovery, it is necessary that… the retail investor base expands."

On the last question, on the shift in preference for debt in the FII segment, a paper by O Attanasio, S Kitao, and G Violante titled "Global Demographic Trends and Social Security Reform" (Journal of Monetary Economics, 2007), provides the answer. This study claims that the impact of demographic transition on US wage growth crucially depends on the mobility of capital between China and India. The study concludes that with capital mobility, US wage growth will be 6 per cent higher by the end of the 21st century, and that the degree of capital market liberalisation will determine the fortunes of the developed world.

The shift in FII preference for debt can be explained by the possible deterioration of solvency ratios of defined benefit pension funds in a QE reversal scenario and an asset-liability mismatch owing to ageing populations in developed countries. As can be inferred from Attanasio et al, by encouraging capital mobility it may be possible to shift a part of the demographic burden to young populations in developing countries in favour of ageing populations in developed countries. A shift in the demographic burden can, thus, be effectively engineered by a change in ownership pattern of domestic government debt.

Though India's entry into the global indices is a welcome step, the subsequent change in policy on the domestic debt ceiling should be examined. The proposed measure is also closely linked to the sufficiency of pensions drawn in the long run by the young generation through the new pension architecture promoted by the Pension Fund Regulatory & Development Authority. It is, thus, appropriate that our commitment to capital account convertibility is juxtaposed with the long-run interest of our demographic dividend.

The author is chief economic advisor, State Bank of India. Co-authored with Saket Hishikar, Economist at SBI. These views are personal