Transforming India’s Fiscal Landscape and Investor Demand

By Consultants Review Team Sunday, 22 October 2023

JP Morgan Government Bond Index - Emerging Markets represent a combination of good news for the Indian economy and a growing demand for increased fiscal transparency and accountability?

Before delving into this strategic move, it's critical to examine the key statistics that underpin its justification. India has an ambitious goal of becoming a $5 trillion economy by the end of this decade. To realize this audacious aim, the Indian government has laid out an ambitious plan that includes the construction of 30,000 kilometers of roads, the expansion of over 200 airports, and the doubling of current port capacity.

However, in order to realize the government's ambition of a $5 trillion economy, significant resources must be allocated to infrastructure development. The crucial concern is how the administration intends to generate the necessary funding for these massive undertakings. The option is deceptively simple: taxation or bond issuance.

On September 8, 2023, India's government bond market was worth $1.3 trillion, but total foreign portfolio investment (FPI) holdings were only $8.5 billion. There was a cap on foreign investment in the Indian government bond market before the Reserve Bank of India launched the Freely Accessible Route (FAR) window in March 2020. Foreign investors also had to change their foreign cash into Indian rupees in order to purchase bonds.

Furthermore, the issue of double taxation discouraged overseas investors. Other issues, such as the country's risk profile, fiscal transparency, political stability, and ease of doing business rankings, further deterred international investors from actively investing in the Indian bond market.

In response to these problems, the Reserve Bank of India launched the Freely Accessible Route (FAR) window in March 2020, in cooperation with the Indian government. This novel measure addressed a number of critical issues. The RBI reduced the investment amount cap for foreign investors as well as the currency exchange issue under FAR.

However, the critical question remains: what amount of foreign investor activity in the Indian bond market has occurred under the FAR framework? FPIs held 2.5% of the outstanding FAR securities as of September 21, 2023, totaling $8.5 billion.

According to several market estimates and our estimations, the involvement of Foreign Portfolio Investors (FPIs) is estimated to reach 18-20% of the outstanding FAR securities. Let us look at the story that led to JP Morgan's decision to incorporate Indian bonds in its Bond Index. 

Many portfolio investors closely monitor key bond indexes such as the JP Morgan Bond Index, Bloomberg Barclays, and FTSE Russell in order to exceed them in terms of returns. In order to replicate portfolios or outperform index returns, these investors establish holdings in emerging market bond markets such as China, Indonesia, and Brazil. Indexes in this context evaluate the performance of international government bonds issued by developing market countries such as India. However, India was not included in their basket or index.

Their reasoning was based on the idea that Indian government bonds did not match the strict conditions they had set. As a result, any investor looking to build a government bond portfolio often overlooks Indian government bonds. Fund managers were primarily concerned in matching the performance of indices developed by firms such as JP Morgan, which did not contain Indian government bonds. This absence cost India a large amount of prospective foreign investment.

In 2019, when China was added to yet another prestigious index, the Bloomberg Barclays Global Aggregate (BBGA), India stood out as the only major emerging economy not represented in these indices.

As a result of this circumstance, the Indian government began steps to engage with major index providers in order to incorporate Indian bonds in their indices. This project began in 2013 and was completed after a decade of hard work.

JP Morgan made an important announcement only last month. They announced intentions to integrate 23 Freely Accessible Route (FAR) securities into their Emerging Market Bond Index, which would be phased in over the next ten months, beginning in June 2024. Although the difficulties of settling transactions through the Euroclear system and navigating the tax implications of capital gains have delayed India's inclusion, it is worth noting that the other two major bond index providers are also expected to follow suit and include Indian bonds in their indices. 

The possibility for foreign capital to flow into domestic government bonds is determined by the index's weight and the AUM linked with it. 

Aside from the government's aggressive efforts, numerous other critical elements have greatly contributed to India's admission in the global bond index. These variables include Russia's exclusion from the bond index, China's economic slowdown, and investors' increasing desire to include India.

Now, let's look at the second component of this story, which is as important to understand: the growing need for increased fiscal openness and responsibility. The inclusion of Indian bonds in various indices increases the Reserve Bank of India's (RBI) and government's obligations significantly. How will these responsibilities be distributed? Before delving into an answer to this issue, it's critical to understand why Indian assets are more appealing to foreign investors. The attractiveness stems from several main elements, including the Indian rupee's stability in comparison to other major Asian currencies, which is supported by macroeconomic stability, improving external fundamentals, lower inflation, and positive growth differentials. 

Despite these favourable elements, inherent downside risks heighten the Reserve Bank of India's (RBI) responsibility, requiring it to be more responsible and accountable. Inclusion in bond indexes raises the risk of outflows, which are frequently caused by causes unrelated to the recipient country's economic fundamentals. This trend emphasises global financial and market circumstances, rather than country-specific macroeconomic issues, as causes of these flows. As a result, increased reliance on external sources might magnify financial market volatility and exert pressure on the exchange rate, influencing imported inflation. Another distinguishing feature of these indices is their sole concentration on investment-grade assets. 

As a result, any negative sovereign credit rating event has the potential to cause a weight reduction and capital outflows. Having said that, it is critical to emphasize the significance of fiscal discipline at the sub-sovereign level.

A critical first step for the government is to revise the Fiscal Responsibility and Budget Management (FRBM) law in order to provide investors with a clear fiscal trajectory. A revised FRBM would not only provide transparency, but would also define the government's approach for decreasing its debt burden in the coming years.

Furthermore, foreign investors will be paying closer attention to India's balance of payments and current account condition. As a result, India must continue to work to improve its macroeconomic fundamentals, focusing on fiscal discipline and sustainability.


Current Issue