Turning point for Bond Markets?

Global Index Inclusion is set to change the contours of capital flows to India.

Budgets are an occasion to make ballistic statements. Though every such statement is dissected to the last word or digit by the frenzied media on the budget day, they are quickly forgotten in no time.  Historically, beyond theatrics, budgets have rarely delivered on the ground. As a result, over time, budgets have come to be seen as an exercise that is sweeping in scope, but short on specifics. But over the last two years, something seems to be on a serious mend, esp. after the current team took the control of the North Block. Of course, the initial slips were scary from this team. That refers to the regressive start in 2019.  After that slippery start, the team seems to have moved very high on the learning curve. One may be wondering why we are talking about budgets when the next one is many months away. Because the bond market story and budget 2020 are closely connected. Here is how. 

To attract capital flows in bond markets, budget 2020 announced a programme that allows foreign investors to buy unlimited amounts of select Govt. bonds via its Fully Accessible Route (FAR). This was a major policy shift through which the Govt. sowed the seeds for Global Index Inclusion. On 31st March that year, RBI quickly followed suit by notifying special series of G-secs under “fully accessible route”.

In response to the notification, the finance ministry tweeted: “This will substantially ease access of non-residents to the Indian Govt. securities markets and facilitate inclusion in global bond indices”

Now, more than a year down, that prospect looks close and real. Come 2022, Morgan Stanley says, India is likely to be added to global bond indexes which will bring one-off index inflows over $40Bn in 22/23, followed by annual flows of over $18Bn in the next decade. That should be music to ears for long-term India Bulls.

Looking beyond the headline-grabbing billion dollar flows, we feel, this will have far-reaching implications in three major macro areas as listed below. 

Cost of Capital:

It is a well-known fact that India’s public debt to GDP is at an elevated  level compared to other EM peers. It is at over 85% of GDP. With growing fiscal pressures, Govt. borrowings are unlikely to soften anytime soon. So far, the public debts have been primarily funded by Indian banks via the SLR (Statutory Liquidity Ratio) mechanism. With significant rise in Govt. borrowings over last few years,  RBI had to come to the rescue in many auctions because of surge in supply of Govt. papers. This had meant the yields have remained higher than policy rates (spread of about 2.8% on 12-month trailing basis). This is precisely where the index inclusion will do its magic. With new demand for papers from the foreign funds (index-tracking funds), yields can track the policy rates much more closely and thus bringing down the overall cost of capital structurally. As per some estimates, the foreign ownership of G-secs could rise to over 9% by 2031 from the current level of 1.9%.  

Currency:

India has historically run a current account deficit of around 1.8% of GDP (going by last 10 years). This is unlikely to change in the coming years. Though, handling BOP (Balance of Payments) has never been a challenge because of FPI and FDI inflows, opening up India’s bond market will help diversify the sources of capital in a phased manner and thus bringing more stability and strength to the Indian Rupee. Most of the brokerages now expect the overall balance of payments to remain in surplus in the range of 1.5 to 1.7% of GDP in the next 10 years because of index inclusion. This means that we may continue to see a surge in forex reserves.

Investments and Capex:

As highlighted earlier, India’s public debt, so far, has been primarily funded by Indian banks via SLR mechanism. This meant that public spending and public investments have been crowding out private investments. Now, with the opening up of G-secs to foreign funds, it creates a possibility for RBI to reduce the SLR window in the future and thus making more capital available for private investments. For capital-starved countries like India, this means a huge potential for capex driven structural growth.

In conclusion, more than anything, in opening up the Govt. securities to foreign investors, one sees India’s growing confidence in the overall macro stability in terms of price (inflation and currency), fiscal (Govt. spending) and monetary policies (interest rates). In our view, this is the biggest takeaway from this yet another reform measure from this administration. In the same breath, it is also important to highlight that how this opening up will bring much required discipline to the current and future administration/policymakers by rewarding or punishing pro-growth or regressive policies respectively. Future Governments will have to think not twice, but many times, before stepping onto any slippery (regressive) policies. That is a huge structural positive for long-term growth. Interesting times to watch out for!!

This article of mine was published in the online edition of Economic Times (02/10/2021). Glad to share the link: https://economictimes.indiatimes.com/markets/bonds/turning-point-ahead-for-indias-bond-market-whats-in-it-for-you/articleshow/86683750.cms?from=mdr