India is inching toward a major milestone: opening its $1 trillion government bond market to more international investors, one of the most ambitious attempts to attract foreign inflows since the country liberalized its economy three decades ago.
Policy makers have spent months preparing to join global indexes, key benchmarks that increasingly determine how large asset managers allocate their capital. And now, after a series of fits and starts, analysts expect the world’s last big emerging market to finally get the nod this year or early 2023 by providers such as JPMorgan Chase & Co. and FTSE Russell.
Entry into major indexes is a step change for India, which has long lagged behind peers like Brazil and South Africa in tapping global financial markets. Foreign investors hold only about 2% of all outstanding government securities and the country’s central bank has historically been averse to large debt inflows.
But inclusion may finally make India a hot ticket for capital: In the three years since China was added to global indexes, foreign ownership of the nation’s government bonds rose to almost 11%, up from 7.6%, leading to a boost in confidence in its fixed-income market and internationalization of the yuan.
Prime Minister Narendra Modi needs overseas buyers. Local demand for government debt is drying up and the Reserve Bank of India is no longer buying bonds. But big investment banks expect index inclusion to prompt one-off flows of $30 billion to $40 billion. That amount would fill a funding gap, lower public-borrowing costs and potentially strengthen the rupee.
For Wall Street and the City of London, India’s inclusion offers an opportunity to diversify holdings and penetrate deeper into an economy that’s growing at one of the fastest paces in the world.
Nivedita Sunil, the portfolio manager for Asia and emerging-market debt at Lombard Odier in Singapore, called India “an attractive alternative” to its regional peers, in part because of “high domestic ownership owing to high domestic savings rates and relatively low correlation to other EM global bond markets.”
Banks including Morgan Stanley expect inclusion to some indexes as early as the second quarter. JPMorgan Chase and FTSE Russell have India on their watch-lists. There is currently no estimated timeline for India’s inclusion to the Bloomberg Global Aggregate Index, according to Steve Berkley, the chief executive of Bloomberg Index Services Ltd.
“We will continue to carefully review and consider operational reforms taking place in India, alongside feedback from global investors, before making any decisions,” he said.
Bloomberg LP is the parent company of BISL, which administers indexes that compete with other providers.
Still, admittance to the gauges is not a done deal.
A capital gains tax on foreigners who invest in local debt has held India back, as has a cap of 6% on global ownership of government bonds. India has also been trying for years to get its bonds on international clearing platforms like Euroclear, which investors often see as a sign that index inclusion is imminent.
To remove barriers, India made the cap flexible in 2020 by allowing a new set of bonds to be fully eligible for foreign ownership. The national budget in February may exempt Euroclear settlements from taxes, too, further paving the way for inclusion, Bloomberg News reported in November.
But embracing an open bond market is still a change of mindset for India. The central bank has tended to see international debt inflows as volatile and adding to the headache of managing a partially convertible rupee, as opposed to a fully floating one like most Group of 10 economies have. A large outflow from foreign-bond investors in 2013, for example, coincided with a steep drop in the rupee.
While capital from index inclusion is less sensitive to domestic turbulence, recent IMF research found that inclusion inflows are between three to five times more reactionary to global financial conditions.
Skeptics argue that inviting more investors from abroad to hold government debt will also add too much scrutiny to meeting fiscal deficit targets. That could place some limits on India’s spending for welfare programs and support during crises such as the pandemic.
In any case, harnessing outside capital to fund India’s growth needs has been a long-standing goal and bond inclusion could have added importance this year. The Reserve Bank of India has started unwinding its easy monetary policy, which is posing a challenge to local debt investors. The central bank may hike rates later this year as economic recovery from the pandemic picks up.
“As growth revives, commercial banks would shed their statutory holdings of sovereign bonds and incrementally reduce their appetite at government auctions,” said Saurabh Bhatia, the head of macro strategy and fixed income at Sapient Wealth in Mumbai. “This makes 2022 an opportune time for bond inclusion to ensure the fast rise in sovereign yields doesn’t jeopardize growth.”
But there are some signs of a disconnect between the kind of yields investors want and what India’s central bank finds acceptable as it nurses Asia’s third largest economy back to health. The 10-year yield is at a two-year high. A new 10-year bond sale ran into weak demand at an auction last week, highlighting the challenges facing next year’s borrowing program.
With little sign of respite from higher U.S. Treasury yields, along with the prospect that India once again ramps up spending to control the omicron variant, index inclusion could be key for keeping yields under control. For investors in emerging market sovereign bonds, greater access to Indian debt may prove valuable in protecting returns in an environment of rising international rates.
“For foreign investors that have never invested in India, this will put it on their radar,” said Kenneth Akintewe, the head of Asian Sovereign Debt at abrdn, which has been a long-term investor in the nation’s debt market. “Whether against a portfolio of global bonds or emerging market bonds in particular, this market has something significant to offer for them in terms of building better diversified portfolios.”