Why JP Morgan’s Inclusion of Indian Bonds in the JP Morgan Government Bond Index – Emerging Markets Signifies a Mix of Positive News for the Indian Economy and a Growing Demand for Enhanced Fiscal Transparency and Accountability?

Before examining this strategic shift, it’s crucial to scrutinize the relevant statistics underpinning its rationale. India holds an ambitious vision of transforming into a $5 trillion economy by the close of this decade. To realize this bold vision, the Indian government has outlined an ambitious blueprint, encompassing the construction of 30,000 km of highways, expansion of over 200 airports and a doubling of the current port capacity.

However, to actualize this vision of a $5 trillion economy, the government must allocate substantial resources to infrastructure development. The pivotal question is how the government plans to raise the necessary funds for these monumental endeavours. The answer is deceptively simple: through tax collection or bond issuance.

Today, let’s delve into the second avenue: bond issuance. Traditionally, the Indian government would turn to the Reserve Bank of India to issue bonds in the domestic market. Who were the primary investors? Typically, domestic investors formed the bulk of government bond buyers, with foreign investors playing a minor role. Several factors contributed to this dynamic.

As of September 8, 2023, India’s government bond market boasted a size of $1.3 trillion, while the total foreign portfolio investment (FPI) holdings stood at a mere $8.5 billion. Before the Reserve Bank of India introduced the Freely Accessible Route (FAR) window in March 2020, there was a cap on foreign investment in the Indian government bond market. Additionally, foreign investors faced the hurdle of converting their foreign currency into Indian rupees to purchase bonds.

Also Read: Government Bond Index-Emerging Market: A win-win for India and investors

Furthermore, the issue of double taxation acted as a deterrent to foreign investors. Beyond these financial considerations, other factors such as the country’s risk profile, fiscal transparency, government stability, and ease of doing business rankings further discouraged foreign investors from actively participating in the Indian bond market.

In response to these challenges, the Reserve Bank of India, in consultation with the Indian government, introduced the Freely Accessible Route (FAR) window in March 2020. This innovative measure addressed several key issues. Under FAR, the RBI eliminated the investment amount cap for foreign investors and the currency exchange issue.

Yet, the crucial question remains: what has been the level of foreign investor participation in the Indian bond market under the FAR framework? As of September 21, 2023, FPIs held 2.5% of the outstanding FAR securities, equivalent to $8.5 billion.

Based on various market estimates and in our estimation, it is anticipated that the participation of Foreign Portfolio Investors (FPIs) is likely to reach approximately 18-20% of the outstanding FAR securities. Let’s examine the narrative behind JP Morgan’s decision to include Indian bonds in its Bond Index. 

Numerous portfolio investors diligently track major bond indexes like JP Morgan Bond Index, Bloomberg Barclays, and FTSE Russell, striving to outperform them in terms of returns. In their pursuit of replicating portfolios or surpassing index returns, these investors establish positions in the bond markets of emerging economies, including countries such as China, Indonesia, and Brazil. Within this context, Indexes assess the performance of international government bonds issued by emerging market nations, including India. However, India was absent from their basket or index.

Their rationale rested on the belief that Indian government bonds failed to meet the stringent criteria they had established. Consequently, any investor seeking to construct a government bond portfolio typically omitted Indian government bonds. Fund managers were primarily interested in aligning their portfolios with the performance of indices put forth by entities like JP Morgan, which did not include Indian government bonds. This absence resulted in a significant loss of potential foreign investments for India.

In 2019, when China found its place on yet another highly regarded index, the Bloomberg Barclays Global Aggregate (BBGA) index, India stood out as the sole major emerging market not featured in these prominent indices.

In response to this situation, the Indian Government initiated efforts to collaborate with these index providers and include Indian bonds in their indices. This endeavour commenced back in 2013 and culminated after a decade of persistent efforts.

Just last month, JP Morgan made a significant announcement. They unveiled their plans to incorporate 23 Freely Accessible Route (FAR) securities into their Emerging Market Bond Index, with this transformation set to take effect in a staggered approach over the next 10 months, starting in June 2024. Although the hurdles of settling transactions through the Euroclear system and navigating the tax implications of capital gains have caused a delay in India’s inclusion, it’s worth noting that the other two major bond index providers are also expected to follow suit and incorporate Indian bonds into their indices. 

The potential for foreign capital to flow into domestic sovereign bonds pivots on the index’s weight and the assets under management (AUM) associated with it. 

In addition to the government’s proactive efforts, several other pivotal factors have contributed significantly to India’s inclusion in the global bond index. These factors include Russia’s exclusion from the bond index, China’s economic downturn, and the mounting demand from investors to incorporate India.

Now, let’s delve into the second aspect of this narrative, which is equally crucial to grasp: the burgeoning demand for enhanced fiscal transparency and accountability. The inclusion of Indian bonds in various indexes brings with it a significant increase in responsibilities for both the Reserve Bank of India (RBI) and the government. How exactly will these responsibilities multiply? Before delving into an answer to this question, it’s imperative to grasp why Indian assets hold a greater appeal for foreign investors. The appeal lies in several key factors: the stability of the Indian rupee compared to other major Asian currencies, underpinned by macroeconomic stability, improving external fundamentals, a relatively lower level of inflation, and favourable growth differentials. 

Also Read: India’s inclusion in JP Morgan bond index could bring $23 billion inflow, says FM Sitharaman

However, amidst these positive factors, inherent downside risks intensify the role of the Reserve Bank of India (RBI), requiring it to be more responsible and accountable. The inclusion in bond indexes elevates the risk of outflows, often triggered by factors unrelated to the recipient country’s economic fundamentals. This shift places greater emphasis on global financial and market conditions as determinants of these flows, rather than country-specific macroeconomic factors. Consequently, this heightened dependence on external factors can amplify financial market volatility and exert pressure on the exchange rate, subsequently impacting imported inflation. Another notable characteristic of these indices is their exclusive focus on investment-grade securities. Consequently, any unfavourable sovereign credit rating event has the potential to prompt a reduction in weight and capital outflows. With that being said, it’s imperative to emphasize the importance of fiscal discipline at the sub-sovereign level.

On the Government’s end, a crucial initial action entails the revision of the Fiscal Responsibility and Budget Management (FRBM) legislation to convey a well-defined fiscal trajectory to investors. Such an amended FRBM would not only offer transparency but also clarify the government’s strategy for reducing its debt burden in the coming years.

Furthermore, it’s vital to recognize that India’s balance of payments and current account position will undergo heightened scrutiny by foreign investors. Consequently, India must persist in its efforts to enhance its macroeconomic fundamentals, emphasizing fiscal responsibility and sustainability

This article has been written by Dr Neelam Rani, Associate Professor (Finance) at IIM, Shillong and Nikunj Bhavna Kikani, an alumnus of IIM Shillong. Views are personal