Exposing India’s financial markets to the vultures

Subject: Economy

Sec: External sector

Context:

In September 2023, J.P. Morgan unveiled its plan to include Indian local currency government bonds (LCGBs) in its Government Bond Index Emerging Markets(GBIEM) Global index suite.
The inclusion is set to be effective from June 2024, prompting anticipation from other index providers like Bloomberg-Barclays and FTSE Russell.

Bloomberg’s Move:

On January 8, 2024, Bloomberg Index Services proposed the addition of India’s “fully accessible route (FAR)” bonds to the Bloomberg Emerging Market Local Currency Index.
This addition is scheduled to take effect in September 2024, aligning with the global trend toward incorporating Indian bonds in benchmark indices.

FTSE Russell’s Watchlist and the Call for Reforms:

FTSE Russell declared India’s retention on its watchlist for a potential upgrade, emphasizing the need for reforms in the government bond market as anticipated by global investors.
The move by J.P. Morgan has triggered a chain reaction among prominent index providers, reflecting a growing interest in Indian bonds on the global stage.

India’s Initiative for Global Bond Market Integration:

India initiated the process of incorporating its government bonds into global indices in 2019, officially allowing foreign investors access to a segment of government bonds by 2020 through the introduction of the FAR.
Despite delays related to capital gains taxes and local settlement, the fundamental policy remained unchanged.

Benefits and Risks Outlined in RBI Report:

A report by the Inter-Departmental Group (IDG) of the Reserve Bank of India (RBI) in October 2022 detailed efforts to internationalize the rupee, emphasizing benefits such as diminishing dependence on domestic institutions and greater stability of funds tracking indices.
The report acknowledges potential risks but asserts that the perceived benefits outweigh them.

Potential Benefits of Opening Local Bond Markets:

Opening local bond markets to foreign investors could facilitate financing of current account and fiscal deficits by engaging institutional investors with long-term investment horizons.
It is anticipated that the influx of funds into LCGBs would lower domestic interest rates, reducing the cost of public borrowing.

Concerns and Risks Associated with Bond Market Internationalization:

The “original sin” problem is addressed by borrowing in local currency, shifting exchange rate risk onto international lenders.
However, internationalization entails a significant loss of autonomy for emerging economies in controlling long-term rates and exposes them to greater interest rate risks.

Volatility and Risks in Foreign Portfolio Inflows:

Foreign portfolio inflows into local currency bond markets (LCBM) are perceived as stable, but they can be volatile due to exchange rate risk borne by investors.
Experiences in Malaysia and Türkiye highlight the potential for sudden stops and exits, leading to reserve losses and currency declines.

Risks Associated with Offshore Markets and Currency Internationalization:

Malaysia’s experience during the 1997 Asian crisis demonstrates the challenges posed by offshore currency markets, leading to speculative activities and financial distress.
Turkiye’s recent experience in 2022, with the offshore lira market in London, also indicates the potential for speculation against the domestic currency.

Y.V. Reddy’s Perspective and Caution:

Y.V. Reddy, former Governor of the RBI, emphasizes that currency internationalization requires a long evolutionary process and sustained development of the financial system.
The Indian rupee is yet to be regarded as an international currency, and its internalization is likely to be an outcome of continued financial system development and improved economic performance.

Overall Assessment and Caution:

The internationalisation of bond markets and currencies in emerging economies is often presented as a solution, but the risks involved are underestimated.
Increased exchange rate instability and boom-bust cycles in capital flows may be likely outcomes, posing challenges to managing financial integration effectively.