Gateway to global capital

India's inclusion in a prominent Global Bond Market Index marks a significant milestone, allowing the nation's vibrant USD 1 trillion bond market to seamlessly integrate with global investors. This development opens-up new avenues for India's economic growth and financial stability. JP Morgan's announcement that Indian Government Securities (G-Secs) will now feature in its prestigious global emerging market bond indices (GBI-EM Global index suite) has garnered considerable attention. This development offers a host of opportunities for India's economic expansion and financial stability.

Historically, foreign investor participation in Indian markets has been lackluster, if not virtually nonexistent. However, this inclusion has the potential to inject a substantial influx of USD 25-30 billion (equivalent to approximately Rs 2.5 lakh crore) into India's financial markets over the coming 18 months. The anticipation surrounding this move has stirred significant market excitement, with a noticeable uptick in trading activity, especially in the long-dated bonds. It is likely to offer enhanced foreign investment at relatively attractive rates as the benchmark 10-year G-Sec yields for India stood at an encouraging 7.10 per cent on September 24, 2023.

This momentous development signifies a promising new chapter for India, as it opens the door to increased global investment and a deeper integration of its bond market with the broader international financial landscape.

A reckoning opportunity

India’s inclusion to JP Morgan Emerging Market-Global Bond Indexing is a reckoning opportunity as it allows India to tap into a more extensive pool of global investors amid growing pressures on its foreign exchange reserves, with burgeoning current account deficit and resultant weakening of rupee. This can lead to an increased foreign investment in India’s G-Sec bonds, facilitating funding of infrastructure projects and stimulating resilient and inclusive economic growth. Moreover, it can result in lower borrowing costs for the government and associated public undertakings. This is because inclusion implies greater liquidity and reduced risk, making Indian bonds more attractive to investors.

Being part of a global index enhances India's visibility in the global financial markets, as a large chunk of qualified investors follow this index. This can lead to increased attention from institutional investors and greater demand for Indian bonds. Resultantly, it can add Indian government bonds to their portfolios, thus diversifying sources of funding and reducing overall portfolio risk.

It is touted that India’s inclusion in the global bond index can attract as much as USD 33 billion (10 per cent of global USD 333-billion market) of investment starting June 2024; however, actual inflow will be gradual and in phases, as only 1 per cent will be added on a monthly basis, to be completed by March, 2025. Moreover, the bond investments are also subject to a host of other factors such as the contemporary regulatory framework, global bond market dynamics, economic and political stability, and India’s business environment. India’s policymakers have got another lever to promote greater foreign investment which can help them stabilize the Indian rupee, especially during the times of enhanced volatility caused by multiplicity of factors. It may also encourage the development of India's financial markets, including improvements in trading infrastructure and regulatory standards.

Potential challenges

The inflow of such a large chunk of foreign investment in a short time window can lead to market volatility due to sudden inflows and outflows of capital, impacting exchange rates and bond yields. When foreign investors hold Indian bonds, they are exposed to exchange rate risk; and associated movements in the Indian rupee can affect the returns for these investors. Moreover, changes in government policies or regulations can impact the attractiveness of Indian bonds to foreign investors. Any adverse policy changes can lead to capital flight.

It also exposes us to macroeconomic vulnerabilities, as India's economic and fiscal situation can affect the performance of its bonds due to factors such as high rates of inflation, fiscal deficit, or geopolitical tensions. Consequently, the global investors may be concerned about the creditworthiness of Indian issuers, as the government's fiscal health and the credit quality of Indian corporations issuing bonds can influence investor sentiments.

Regulatory framework

In the light of India's inclusion in a global bond index, the Reserve Bank of India (RBI) assumes a central role in managing market dynamics, ensuring the competitiveness of the Indian Rupee, and addressing the challenges posed by sudden capital flows, both inflows and outflows that may trigger market volatility.

First and foremost, the RBI's prudent management of foreign exchange reserves is paramount. In cases of excessive capital inflows, the RBI can absorb surplus liquidity by acquiring foreign currency assets. This strategic move mitigates the upward pressure on the Indian Rupee, safeguarding its competitiveness. Conversely, during episodes of capital outflows, the RBI can deploy its reserves to stabilize the exchange rate, preventing sharp currency depreciation. This dual approach serves to strike a balance between promoting economic stability and maintaining a competitive exchange rate.

Additionally, the RBI possesses a set of powerful tools to navigate capital flow dynamics. It can implement capital flow management measures, such as adjusting foreign portfolio investment limits and enacting temporary capital controls. These measures act as circuit breakers, effectively moderating the pace and magnitude of capital flows and preventing extreme market movements. Furthermore, the RBI has the capacity to influence investor sentiment through interest rate policy adjustments.

Market surveillance and effective communication form the core of the RBI's strategy, as detecting irregular market movements early allows for timely intervention. Moreover, it clearly shows the RBI's policy intentions to guide market expectations, thus reducing uncertainty and reinforcing investors’ confidence.

Lastly, the RBI can fine-tune liquidity conditions in the banking system through open market operations (OMOs) and diverse policy instruments, thereby maintaining financial stability and preventing disruptions stemming from liquidity shortages.

India's inclusion in a Global Bond Market Index signifies a transformative opportunity for the nation's bond market, offering both benefits and challenges. The precise impact will depend on India's economic and political landscape, as well as evolving global market conditions.

The writer is a professor at IIFT New Delhi. Views expressed are personal