After three long years, foreign portfolio investors (FPIs) have once again turned buyers in India’s bond markets. It is not as though yields are now more attractive, they are not. What is whetting their appetite is the prospect Indian bonds could soon be included in a couple of global bond indices. It is not certain India will make it in the next round of reviews (due soon), but the chances are bright. Indeed, both RBI and the finance ministry have been on the job for some time now; they have been trying to make sure the settlements process will be a smooth one and have also been figuring out taxation issues with Euroclear. RBI Governor Shaktikanta Das observed a few weeks ago that both the issues were “work in progress”.
While India’s bond markets have been open to foreign investors for many years now—opened up in a phased manner—the inflows have been modest at less than $40 billion in the last decade. That should change significantly once Indian bonds find a presence in global bond indices. Morgan Stanley estimates inflows of close to $18.5 billion annually, over the next ten years. Analysts at Bank of America wrote recently Indian bonds are likely to get a weightage of 9-10% in the JPM GBI-EM GD, which works out to $22-25 billion, and another estimated $7-8 billion if the bonds get close to 0.35% weight (based on market capitalisation) in the Bloomberg Global Aggregate index.
The advantages of a membership to bond indices are well-known. Once there are more foreign investors in the market, the pressure on local ones—primarily the banks—to support the borrowings of the Centre and the states will ease. Also, experts believe that the bond holdings would be imparted a degree of stability given some portion of these would be owned by passive investors. They point out the long-term benefits of in terms of more room on banks’ balance sheets and lower funding costs for the government and corporates would far outweigh the potential capital gains taxes foregone.
However, to what extent the government is willing to give up tax revenues on international bond transactions, remains to be seen. Clearly, things will move faster if New Delhi is willing to exempt the transactions from capital gains tax; the process would be far simpler and the returns for foreign investors too would be bigger translating into larger inflows. That would lower the cost of borrowing not only for the government but also for companies. To be sure, debt capital flows can be a lot more volatile than equity flows; sudden and large outflows could leave the markets, and the currency, in turmoil. In India, too, equity flows have been seen to be much more stable than investments in bonds. That is one reason New Delhi has been reluctant to allow foreign investors a free play in the country’s bond markets and, in 2016, had initiated a medium-term framework to increase the quotas every quarter subject to a cap of 6% on government bonds. In 2019, a voluntary retention route was brought in with a minimum retention period, typically three years. Even today, several restrictions remain on holding periods and full access is provided only to certain categories to bonds. However, given the war chest of $600-billion-plus of forex reserves, RBI probably is confident of being able to handle any sharp volatility in the markets.