India will now be a part of JP Morgan's Government Bond Index-Emerging Markets (GBI-EM) Index, attaining a maximum weighting of 10%, scheduled to begin on June 28, 2024, extending over 10 months with 1% increments on the index weighting.

One can think of it as the financial equivalent of the cool kids' table in the school cafeteria. You know the one: it's where all the attention is, and being part of it instantly elevates your status. It is this moment when India is walking with its head held high and earning a nod of acknowledgment from the financial world.

Like the cool gang's table, everyone wants to sit there because they're considered the safest and most attractive investments. India has been on Index Watch Positive since 2021 for inclusion into the GBI-EM, following the Indian government's introduction of the FAR program in 2020 and substantive market reforms for aiding foreign portfolio investments on taxation and settlement mechanisms. 23 Indian government bonds designated under the Fully Accessible Route (FAR), with a combined notional value of approximately INR 27 trillion / US$ 330 billion, are index-eligible.

But is this the only table (global bond index)? No. There are two more prominent global bond indices - The FTSE EM Index and the Bloomberg Barclays EM bond index. It is speculated that these two would follow suit and include India over the next couple of months. The journey, however, is not so smooth as the procedural criteria and conditions are stricter, and they might depend on overcoming operational challenges like custody and settlement, understanding taxation, and Euroclear.

Nevertheless, India's much-awaited inclusion into JP Morgan's emerging market bond index is big news. Let's understand why's that? In our article last year (https://www.alphacapital.in/blog/joining-the-club-whats-the-worth-of-the-membership), we illustrated why index inclusion matters in the context of stocks included in different indices like NIFTY. The principle channel remains the same!!

Being part of the cool gang has its perks: you get invited to more parties, make new friends, and become a trendsetter. Similarly, India's inclusion in the Global Bond Index means access to a broader pool of global investors, lower borrowing costs, and increased opportunities for economic growth. Some of the other benefits are increasing visibility and accessibility, strengthening the financial system, Alignment with global standards, Boosting investor confidence, and improving diversifying opportunities.

The most critical implication for India is that this could lead to billions of dollars of foreign inflows into India. Technically, the GBI- EM Global Diversified Index accounts for $ 213 Billion, with a maximum staggered weightage of 10%; approximately $21 Billion can flow into Indian bonds. Thus, passive funds inflow begins on June 28, 2024, and is expected to be completed by April 2025. Additionally, active funds would start pouring money into the Indian bond market quickly, resulting in an aggregate of more than $40 billion, in contrast to a mere 2 billion dollars presently invested in the Indian market.

The move will make it easier for India to pay for its twin deficits – fiscal deficit and current account deficit. This liquidity in the bond market would ease the fiscal deficit pressure. In conjunction, the capital flows would balance out India's high current account deficit. A few other implications of India's inclusion are:

• In the short run, huge money inflow would reduce the bonds yields. As is evident from the day the news came, the yield of 10 year government bond fell from 7.14% to 7.08%, and it will continue to fall (The net effect, on account of US yields and dollar index, is difficult to gauge)
• Banks can show better profits on account of the mark-to-market valuation of their bond portfolio, owing to decreasing bond yields and the recent RBI regulatory changes on how banks should value the bond investments on their books.
• Corporate borrowers will also benefit because their interest rates will be based on those of government bonds. Declining government bond yields would lead to a fall in corporate bond yields, reducing the borrowing cost for the borrowers.
• With a deepened bond market, long-term funding of infrastructure can be seen as a possibility in the long term.
• The rupee would become stronger, though RBI would monitor it regularly.

Potential drawbacks or challenges associated with the inclusion of a country's bonds in global bond indices like JPMorgan's Emerging Market Bond Index (EMBI) are increased market volatility, exchange rate risk, capital flight, market distortions, increased speculation, and regulatory and legal pressures. 

In July 2023, RBI stated that the gains of inclusion outweigh the risks. Thus, there is some caution that investors must exercise when making decisions. One of the significant risks is associated with 'Taper Tantrums' (https://alphacapital.in/blog/no-more-taper-tantrums-please), which puts tremendous pressure on the rupee. The RBI group report noted that index inclusion could lead to "increased sensitivity of domestic policy to external spillovers," and fiscal and monetary policies will need to be "more cognizant of global perception and sensitivities."

It is at our own peril to ignore the lessons that can be learned from other economies – for instance, Egypt is on a negative index watch because of the forex repatriation hurdles. We should not forget the role played by the exclusion of Russia and the associated challenges with China. 

Moreover, India must take note of the rule change starting January 31, 2024; bonds released in global format from index-eligible markets will have to undergo a more thorough screening for liquidity. Only global bonds from countries with primary market activity (new issuance and/or taps in global bond format) in the last 24 months (evaluated at each month-end rebalance) will stay eligible for the Index. This rule change results in the exit of three global bonds (from Brazil, Colombia, and the Philippines)  from the Index. 

Finally, India is on the global stage, and it's a moment of pride. As we watch India's journey to the cool gang's table—the Global Bond Index—let's remember that this achievement comes with added responsibility. To maintain investor confidence and attract foreign investment, the Indian government may need to demonstrate fiscal discipline and responsible economic management. India's economic and financial policies may come under increased scrutiny from international investors, credit rating agencies, and global financial institutions. This could put pressure on the government to maintain transparency and implement sound economic policies.

In summary, the inclusion of Indian bonds in an emerging market index can bring several benefits, including increased foreign investment and liquidity, lower borrowing costs, and potential currency appreciation. However, it also comes with risks, such as capital flight and exchange rate volatility. India would likely need to make efforts to improve its economic fundamentals and policy frameworks to maximize the positive effects of inclusion in such an index.

My dear readers, remember the big global picture will always be more critical, and there are still problems that should not be forgotten. Over time, the continuous reform process, more accessible market access, and transparency will shape and accelerate the country's integration into global markets, enabling unmatched market development, long-term capital inflows, and innovative financial products.

Stay Informed !!

Best Regards
 
Dr. Tarunika Jain Agrawal Ph.D. 

Alpha Research