JPMorgan Index Inclusion: A Policy Ballet In Balancing Independence And Capital Flows

India’s inclusion in JP Morgan’s Bond Index has been received with market euphoria, at least at commentariat level. In a note, JP Morgan said India is expected to reach the maximum weight of 10 per cent in the GBI-EM Global Diversified Index (GBI-EM GD). Starting June 2024, Indian Government Bonds (IGBs) will be included in the index, at the rate of 1 per cent every month for the next 10 months.  

Inclusion of Indian bonds in global indices has been a long effort, dating back nearly a decade. It has taken time – taxation on bond investments and restrictions on foreign investment have been the primary hindrances. The latter was finally addressed in 2020, when Reserve Bank of India (RBI) introduced a few designated securities under a programme called "fully accessible route" (FAR), where foreign investment restrictions were removed. In some ways, it reflected India’s growing confidence in macro-management, as large foreign flows do tend to reduce policy flexibilities at the margin.  

Inclusion in a key benchmark index should enhance foreign investment into IGBs. Incremental foreign flows will help finance the Current Account Deficit (CAD), reduce IGB yields and downstream cost of borrowing for private companies. Some breathless forecasts about Indian Rupee (INR) appreciation have also been made. However, there is never a free lunch, is there?

How The System Works

Currently, India funds most of its fiscal deficit, in most years exceeding 95 per cent of requirement, via domestic savings. Banks, Mutual Funds and Small Savings scheme are the biggest investors in IGB. In this, India’s one of the few outliers in the Emerging Markets (EMs) world, with only a few East Asian economies in company in that corner. Most EMs are substantially (some chronically) dependent on foreign savings to fund their deficits. For India, this is made possible by three enabling conditions. First, a deep and sophisticated banking and capital market. Second, high domestic savings rate (though somewhat lower than East Asian levels) that enables our financial markets intermediate these savings into IGB. Lastly, high quality, and sometimes restrictive, regulations by RBI, which enable both efficient intermediation as well as a tight grip on market participants to manage imbalances. RBI’s role as both the banking regulator as well as the banker to the government means it is a rules maker and a market participant at the same time. Ergo, bond prices are marked as much to RBI regulation as they are to market sentiments.  

The system has served India well. Barring a small blip in 2013, India hasn’t confronted a macro crisis since 1991, despite unstable global macros. At the same time, it has retained policy flexibility to attain broad macro objectives. Its glaringly evident today, when a sharp monetary tightening in the US has not required a similar tightening in India. So much so, the spread between US and Indian interest rates are at near all-time lows. This has helped the economy maintain a fragile post-Covid recovery, which would have gotten derailed if Indian interest rates went up as much as US rates have.  

Its precisely why policymakers have been traditionally wary of encouraging large foreign flows into bonds – cost-benefit between incremental flows and loss of policy flexibility was skewed in negative territory. Its illustrative that despite a decade-old effort of getting IGB in global bond indices, the government did not relent on one key demand of index providers, I.e., favourable tax treatment for foreign investors.  

What Will Change With More Foreign Flows?

The biggest change will be in loss of policy independence. Unlike domestic market participants, foreign investors are not subject to RBI rules on liquidity, valuations, minimum threshold holdings et al. Beyond cross-border investing rules, they are also not subject to RBI’s regulatory oversight on capital requirements, trading rules – tools that are used to nudge (and sometimes shove) market behaviour of domestic participants. While this is good in terms of instilling discipline, marrying that into broader macro objectives (like growth, income support, inflation tolerance etc) is a tough job.  

But this is the price of playing in the bigger leagues. The much-feted/maligned “USD privilege”, isn’t a free option bought by US Navy ships, but costs an enormous amount of economic policy independence given up by the US.  

It's likely that RBI has assessed the impact to be relatively small. While numbers of $20-25 billion upfront by Mar 2025 and annual flows of $40-50 billion have been bandied around, these are to be tested. JP Morgan reports $213 billion of funds benchmarked to the GBI-EM GD index. 10% of that translates to $20 billion – the number that is being widely reported. But in reality, net foreign flows in debt into India have been rather volatile, and often negative. Aggregate foreign holding of debt is quite low. Ergo, it's unlikely active bond investors have been finding IGBs to be of great value consistently. However, there can be investments by passive funds – those that track the index – where flows will be mechanical. It is likely that RBI doesn’t expect flows to be as much as what some of the most enthusiastic market commentary is predicting. Hence, it is comfortable using this as a “sandbox” regulatory experiment of managing with loss of policy flexibility.  

It's clear that with India’s increasing size, there will be new opportunities to embrace. But every new great opportunity will be accompanied by great new challenges, will present newer tests. More so in an economy that is large in aggregate size, but still very poor on average income.  

(The author is the Chief Investment Officer at ASK Private Wealth. The views and opinions expressed in this article are personal)