The math of index inclusion

The case for a capital-deficit emerging market economy like India to dip into the global savings pool to fund its investment needs is rather obvious. You cannot, however, always choose the quality of money you get. The relatively incremental approach over the years from Indian policymakers towards global debt portfolio capital has reflected their concerns about the potential for such flows to engender volatility in asset prices. That the government has announced in the recent Budget its intention of having its bonds listed on global debt benchmarks is, in that context, a significant and welcome step forward. It is arguably India’s best bet to attract the relatively passive and sticky part of global capital looking to invest in fixed income. The choice, however, of a somewhat unconventional strategy of opening up only a limited number of “special securities” to  foreign portfolio investors (FPIs), means it will likely take a few years before India can potentially lean on index driven flows to finance a significant portion of the government’s budgetary needs. 

The math of index inclusion flows depends mainly on the global fixed income benchmarks that could consider India eligible for inclusion; and, the scale/mode of issuance of the new “special securities”. There are two relevant bond benchmark indices that India may be considered for. One is an emerging markets dedicated fixed income benchmark called JP Morgan Global Bond Index–Emerging Markets (GBI-EM), with a market capitalisation of $1.25 trillion and with roughly $225 billion of assets under management (AUM) tracking the index, mostly the global diversified version which caps the weight for an individual market at 10 per cent. The other is the Bloomberg Barclays Global Aggregate Bond Index (Global Agg), which has bonds with a market capitalisation of as much as $60 trillion, and with about $2.5 trillion of AUM tracking the same. In addition to free accessibility and absence of capital controls; the two indices also have other criteria to determine the eligibility of bonds which can be included. The GBI-EM, for example, only considers fixed-coupon bonds with outstanding of at least $1 billion, and with minimum residual maturity of 13 months. It also considers certain liquidity standards, including firm daily prices, reasonable bid-offer spreads and sufficient trading frequency to prevent stale price quotations. The Global Agg, similarly, only considers bonds with minimum issue size of $300 million. Both indices will take into account operational considerations around the ease of account opening, hedging and repatriation, among other things, while deciding on index eligibility.  

The weight for India in either of the benchmarks will be a function of the size of index-eligible “special securities” as a proportion of the total market capitalisation being tracked by the index. As a rough rule of thumb, for example, every $10 billion of index-eligible securities issued by India can help get an additional 1 per cent weight in the GBI-EM Global Diversified Index. In turn, this can attract just over $2 billion of index tracking  global capital from either passive index investors, or assuming active managers are broadly market weight versus benchmark. 

It would, therefore, need the government to conduct a minimum 30 per cent (an estimated $45 billion) of its gross borrowings for the coming fiscal year — both issuance and switches — via the freely accessible “special securities” for India to be included in at least the GBI-EM benchmark, to attract an estimated $8 billion of foreign index capital, or around 10 per cent of the net funding needs of the government for the year. To be sure, this is not unprecedented. Even in FY2019-20, the government conducted 30 per cent of its gross issuance, including switches, via just four benchmark bonds. Repurposing, and reissuing, existing bonds  as “special securities”, instead of issuing new bonds, could help achieve a larger weight in the benchmark indices in a shorter period of time, and increase the potential for more substantial flows. Continuing to use the current benchmark bonds from FY2019-20 as “special securities”, for example, could help double the potential weight in the indices and the scale of index tracking flows.

At their full market capitalisation of around $850 billion, Indian government bonds should ultimately be able to reach the individual market cap of 10 per cent in the GBI-EM Global Diversified Index, and around 1.5 per cent weight in the Global Agg Index. In turn, this could be worth potentially $60 billion plus of index tracking foreign portfolio inflows into the local government bond market in India, equal to almost double the current outstanding holdings of offshore investors. How quickly India gets to tap this scale of offshore financing depends, in turn, on the choices made about the size and mode of issuance of the new “special securities”. Given the difference in scale of market capitalisation of the two indices, and of the AUM tracking the two, it stands to reason that inclusion in GBI-EM can fetch relatively larger inflows in the near term. The Global Agg, on the other hand, has a slower “glide path” to flows, but with potential for a larger total pool to capture. 

The writer is  managing director, head of Asia macro strategy, Deutsche Bank