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India’s Inclusion in JP Morgan EMBI Index: Long Way for Full Global Integration

Despite inclusion in the JPM-EMBI index, fundamental constraints associated with Rupee-denominated GoI bonds remain.

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On 22 September, the long-awaited announcement of including Government of India securities/bonds (GoI bonds) in the JP Morgan global emerging markets bond index (JPM-EMBI) finally materialised.

With about USD 240 billion riding on the JPM-EMBI and the promised weight of 10 per cent in the Index, the prospects of about USD 24 billion inflows coming to India in 2024-25 (Index inclusion takes place in June 2024 with one per cent weight, which rises to 10 per cent over next 9 months) brightened.

Indian policymakers heaved a sigh of relief more on account of the fact that the inclusion happened without the government providing any undue concession like exempting the withholding tax on interest/capital gains of the GoI bonds purchased through the Index-aligned funds/vehicles.

Hopes of this inflow providing a positive impact on the Rupee have also been raised. The investment bankers and bond market wholeheartedly welcomed the development as well.
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The inclusion is undoubtedly significant. Besides relishing the moment, let us also understand its implications better.

What does this inclusion actually mean for India’s long journey towards fully opening up the government bond market to foreign investors? Is this the last step before India musters the courage to issue foreign currency-denominated sovereign bonds?

How much inflows are likely to take place and will these reverse the flow of Foreign Portfolio Investors (FPIs) in GoI bonds? What implications does this development have for the Rupee exchange rate?

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Foreign Investment in GoI Bonds Has Been Steadily Declining in Recent Past

FPIs held, on 31 March 2023, GoI bonds of Rs. 1.31 trillion (about USD 16 billion @Rs 82/dollar ). This amounted to only a little over 1.3% out of total outstanding GoI bonds of Rs 96.46 trillion (about USD 1.175 trillion).

FPIs' investment in GoI bonds was much higher at Rs 1.43 trillion (about USD 20 billion @ Rs 73/dollar) on 31 March 2021 with FPIs commanding a share of 1.9% out of total outstanding securities of Rs 76.34 trillion (USD 1.045 trillion).

In fact, the FPIs had the largest investment in GoI bonds in 2018. On 31 March 2018 when FPIs owned GoI bonds of Rs 2.35 trillion (USD 36.30 billion @Rs 65/dollar) out of total outstanding securities of Rs 53.97 lakh crore (USD 830 billion), giving them a share of 4.4 per cent.

It is worth noting that FPI's holding of GoI bonds has more than halved in the last five years (from USD 36 billion in 2018 to USD 16 billion in 2023).
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India Has Gradually Opened Up Foreign Investment in GoI Bonds

India did not permit foreign investment in GoI securities before 1991.

From the middle 1990s, India began permitting foreign investment in GoI bonds in a cautious and limited way. There was incremental progress over the next 15-20 years with specified categories of non-resident investors permitted to invest in government securities issued by the centre and the states, though FPIs did not invest in state government securities at all.

In 2013, the regime was significantly rationalised. Two broad classes of foreign investors general and long-term investors were created.
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They were permitted to invest in government securities and corporate bonds subject to limits prescribed overall, for each class of investor and each type of security (GoI securities, state government securities, and corporate bonds). The overall investment limit was fixed at USD 51 billion.

In 2018, the Voluntary Retention Route (VRR) was introduced to provide a less regulated regime for those FPIs which committed bond investment in excess of specified limits.

The fully accessible route (FAR) was introduced in March 2020. With this, the foreigners could buy and sell the GoI bonds issued under FAR, without any restrictions.

So far, GoI bonds of about USD 330 billion have been designated 'FAR securities.'
Despite inclusion in the JPM-EMBI index, fundamental constraints associated with Rupee-denominated GoI bonds remain.

India has the third-largest government bond market among EMs. 

Source: Bloomberg

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India’s Efforts To Get Into the International Bond Indices

India has been exploring the possibility of getting its GoI bonds included in the global bond indices for quite some time at least since 2015. Two problems have proved to be intractable thus far.

One, restrictions like category-wise and security-wise limits on purchase/ holding/ sale on FPIs for investing in GoI bonds. The bond indices cannot work with such limits/constraints.

Two, the insistence of the index providers to settle the bond transactions through Euroclear. In the last few years, the demand for tax exemption has also increased.

The FAR regime removed the first constraint. The bond index makers held out longer for Euroclear until JPM-EMBI blinked (other bond indices are still insisting). JPM-EMBI has also abandoned the tax exemption demand.

JPM-EMBI has opened the path of GoI bonds’ inclusion in global bond indices.
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JPM-EMBI Inclusion Will Bring Some Moolah

FPI investment in GoI bonds depend on a few key parameters. The net dollar interest rate on the dollar-invested but in rupee-denominated GoI bonds (the coupon rate minus hedging cost) is the first key parameter. Depreciation of capital invested on maturity/sale of GoI bonds in dollars on account of rupee depreciation is the other.

Appreciation of FPI investment until March 2018 and the steady decline thereafter (from USD 36 billion to USD 16 billion) is explained by the above two key factors.

The index-based investment is not influenced by these factors. Therefore, the inclusion in JPM-EMBI will surely bring in USD 24 billion of inflows. This should take FPI investment in GoI bonds to about USD 40 billion by March 2024.

With inclusion in the JPM-EMBI, present available routes for FPI investment (VRR/FAR, etc) will turn into only alternative modes to the Index route. With index-based bond investment becoming the global fashion, it is quite likely that the FPI investment through the existing routes get emasculated.
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The current FPI investment of USD 16 billion may also see a partial conversion in JPM-EMBI-based investment. Outflows of USD 5-USD 10 billion from the existing FPI investments cannot, therefore, be ruled out.

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Go for Foreign Currency-Denominated Sovereign Bonds

Despite inclusion in the JPM-EMBI index, the fundamental constraints associated with Rupee-denominated GoI bonds remain.

The foreigners make investments in dollars (other currencies). What matters to them are the total returns from investment in GoI bonds in their currencies.

The losses and costs associated with the conversion of dollars/foreign currencies at the time of purchase of Rupee-denominated government securities, receipt of interest/returns, and capital return at the time of sale would not go away upon inclusion in the JPM-EMBI. These will continue to impact the investors’ total returns.

These constraints can only be overcome when India issues foreign currency-denominated sovereign bonds.
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Such sovereign bonds were announced in the 2019-20 budget. The government, however, could implement the announcement. India is the only G20 country which does not issue foreign currency-denominated bonds.

India’s real global bond inclusion and integration would happen only when we can muster courage and begin issuing dollar/foreign currency-denominated GoI bonds.

(The author is former Economic Affairs Secretary and Finance Secretary of India. This is an opinion piece and the views expressed above are the author’s own. The Quint neither endorses nor is responsible for the same.)

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