Confidence booster

Index inclusion reflects confidence in India

Bloomberg’s decision to include Indian government bonds issued under the fully accessible route (FAR) in its emerging market local currency government bond index and related indices gives a significant boost to the Indian debt market. The inclusion will be done over 10 months starting January 31, 2025. Bloomberg will be the second major global index provider -— after JP Morgan — to include Indian government bonds in its emerging market bond index. JP Morgan’s index inclusion will start in June 2024. While Bloomberg’s index inclusion is expected to result in an inflow of only $2-3 billion, coming soon after the inclusion by JP Morgan, which is more widely tracked, it is a confidence booster for large international investors looking to diversify their debt holdings. This should lead to higher inflows in the debt market over time.

It was announced in the Union Budget 2020-21 that certain categories of central government securities would be opened for non-resident investors without any restriction, following which the Reserve Bank of India (RBI) started issuing securities under the FAR. This, as expected, has enabled the inclusion of government of India bonds in global indices. Index inclusion, theoretically, can have several benefits. It will lead to a higher flow of foreign savings, which will not only help the government to finance the fiscal deficit but also aid in financing the current account deficit. Funds tracking these indices are passive in nature and the flows are considered more stable than those managed actively. Since part of the budget deficit will be financed by foreign savings as more securities are issued under the FAR over time, it will relieve pressure on domestic savings, which can help bring down overall borrowing cost in the economy.

At a broader level, the inclusion of government bonds in global indices also reflects confidence in India’s macroeconomic strength. India is one of the fastest-growing large economies with macroeconomic stability. It also maintains large foreign exchange reserves, which has helped maintain stability on the external front, as evidenced during the recent policy tightening by the US Federal Reserve. Foreign portfolio investors pumped nearly $5 billion into the Indian debt market thus far in 2024. Although there are several benefits of index inclusion, it is worth remembering that higher foreign exposure in the debt market can also increase risk. As RBI Governor Shaktikanta Das rightly noted last year, index inclusion is a double-edged sword. While inflows will increase as the weighting in indices goes up in the near term and assets under management tracking these indices grow, the reverse can also happen if India’s weighting is reduced by the index providers.

In such a situation, foreign funds will move out of Indian securities, which can put pressure on both borrowing cost and the Indian rupee. Higher issuance under the FAR, which will be necessary to create a liquid market for foreign investors, can also exacerbate volatility in times of stress. Thus, what this means is higher foreign exposure would demand better and more agile macroeconomic management. In brief, India will need to aim to run a low fiscal and current account deficit, along with low and stable inflation. Although it is being brought down progressively, a higher general government budget deficit in this context remains a vulnerability. The RBI will also have to manage foreign exchange flows actively to limit currency volatility.