The Markets will be entering a new phase from July onwards with the inclusion of Indian bonds in the JP Morgan Index. In fact, after the announcement of inclusion of these bonds in September, there was a gradual build-up of holdings in government securities (G-Secs) by foreign portfolio investors (FPIs). The assets under custody of sovereign bonds held by FPIs climbed from around $19 billion in September-end to $28 billion in mid-June. Clearly some of the players wanted to build their positions in advance to take advantage of the indices, once included. This phase was also associated with considerable activity in the G-Sec and forex market though there were several other factors at play. What can be expected going forward?
The basics can be put together to begin with. The JP Morgan index of bonds involving government paper would assign a weight of 10% to India at the rate of 1% per month. Hence even passive investment in the index would mean some allocation for Indian bonds. Twenty-three securities would qualify for investment where there are norms on the residual maturity as well as amount outstanding. Both are necessary for rebalancing the index. Unlike equity which is perpetual, debt matures at some point of time and would require replacement of appropriate securities. The Reserve Bank of India (RBI) has also included several securities under the FAR banner which denotes fully accessible route, where no limits are placed on FPI holdings. If one were to
between the market and the index, there could be additional inflows as one could take a call on the index and also a position in the particular security. All put together, there are estimates which point to an inflow of $20-25 billion on this score. This comes to around `1.8-2 trillion of potential purchases.
Now, the total borrowings for the year for the government is around `14 trillion. While only some securities would qualify to meet the index criteria, intuitively it can be seen that there would also be secondary market purchases of existing securities and hence it would free funding space of existing holders who could easily subscribe to the new securities issued this year. Hence, there will be easing of liquidity to a large extent as there is a new player in the market. Banks, in particular, will be less pressured to subscribe to these securities and can use them for lending purposes. Therefore, the advantage of liquidity will accrue over time.
Second, as there is more demand for paper, prices would tend to increase given that the supply is limited to existing stock or the announced fresh set of securities. Higher prices in the market would mean lower yields and hence this is something that will happen in the natural course. For banks holding on to paper, there will be mark-to-market gains to be made in such a situation. Also, lower yields across the spectrum of G-Secs without any rate action from the RBI would be indicative enough for other commercial rates to move down gradually. Therefore, the corporate bond market will also witness a decline in interest rates. This is so because corporate bond yields get benchmarked at a premium to the government bond of equivalent tenure.
Third, the fact that around $20-25 billion comes into the market every year would be good news for the forex market where the supply of dollars would increase. Presently our fundamentals look strong enough in terms of current account deficit and other capital flows. These additional FPI flows into debt will further strengthen the situation and make the rupee appreciate. This can counter, to an extent, the external factor of the dollar being strong in the market as long as the Fed holds on to the rates in the US. But this comfort is significant for the market.
Last, there could be collateral impact on equity market too, where foreign investors follow India more closely by virtue of this inclusion although, understandably, the two classes of investors are different. This could, however, be a possibility.
Hence, the immediate effects of these flows appear to be positive all the way. In fact, Bloomberg would be including Indian bonds in their indices from January 2025, which will further improve the situation. But such inflows would also be of concern to the RBI. First, a sudden jump in dollar inflows would also mean that there would be appreciation of currency, which may be tolerable only within limits. Hence, to control this volatility, the central bank would have to buy forex to ensure stability in the currency or else there is the threat of loss of export-competitive advantage.
On the other side, an increased source of funds in the market can cause the same kind of volatility as in the forex and bond markets. While lower yields would be desirable there must be limits here too, as this can come in the way of monetary policy. In FY24, there have been situations where the yield curve behaved differently when the shorter tenures were driven by liquidity while the longer term were tracking Fed actions. Here the securities covered in the index could move more decisively due to the concentration effects. Further, as these inflows will be concentrated in specific securities there could be skewed demand not just in terms of holdings but also trading. This needs to be watched more closely in the coming months.
On the whole, the “bond inclusion” in global indices is a reality and is something the government and the RBI have been working hard for. This does provide the global gravitas that was missing in a market which was largely domestic in nature. Along with this advantage there would also be closer scrutiny by players especially on the fiscal side, as most deficits finally get converted to G-Secs and enter the market which is now global in spirit.
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