Managing flows

Govt's dependence on foreign funds should be limited

JP Morgan’s announcement last week on the inclusion of Government of India (GoI) bonds in its emerging market government bond index led to considerable excitement, both in financial markets and the government. Assets under management worth $236 billion track this index, and since India will have a weighting of 10 per cent, about $24 billion is expected to be deployed in GoI bonds once the process, which will start in June next year, is completed. As assets tracking the index grow over time, so will the flows. Since GoI bonds are being included in a widely tracked index, it is likely that other such indices would also consider inclusion over time. Inclusion in such indices would encourage even active fund managers to increase allocation to GoI bonds.

Thus, the increase in demand for GoI bonds, theoretically speaking, will reduce the borrowing cost for the government. The market did not react in a big way to the announcement because the actual inclusion is still some distance away. Relatively low yields on GoI bonds will also help states and corporations to borrow at a lower cost. Besides, an increase in the flow of foreign capital will help finance the current account deficit. There could thus be numerous benefits associated with the inclusion of GoI bonds in international indices. Since the flows tracking these indices are passive in nature, they are deemed to be more stable. Given the potential advantages, the GoI has been pushing for index inclusion for some time. The Reserve Bank of India (RBI) commenced the issuing of GoI bonds under the so-called fully accessible route to non-resident investors following a reference in the Union Budget 2020-21 that certain categories of bonds will be fully opened to foreign investors.

Although tapping foreign savings to finance the fiscal deficit has some merits, it also carries risks, which is why Indian policymakers have been restrained about opening up the debt market. The fiscal deficit is largely financed through domestic savings. Increased foreign participation, even if the debt is denominated in the domestic currency, will inevitably increase risks. It is worth remembering that even passive flows can exhibit significant volatility at times of macroeconomic instability. This could lead to heightened volatility in both bond and currency markets. An increased level of debt flows could also put upward pressure on the currency, affecting the competitiveness of India’s tradable sector. The RBI, therefore, will need to be more alert and willing to intervene in the market to contain volatility on either side.

At a broader level, if the idea is to lower the cost of money for the system, the more effective way is to run a lower general government Budget deficit — which will reduce the demand on domestic savings and bring down the cost of money — with low and stable inflation. The combined Budget deficit in India is usually higher than that of its peers, which tends to crowd out the private sector. The expanded pool of savings because of the increased participation of foreign investors should not be regarded as a means to run higher Budget deficits. On the contrary, the government will need to be more disciplined. To be sure, at this stage of development, India will need to import capital to fund investment. However, in order of preference, it has favoured direct equity investment because of its underlying advantages. Any change in this stance should be measured.