9 mins read . 17 Oct 2023
It is finally official that Indian government securities will be part of the JP Morgan benchmark index. It had been in the works for a long time and is finally happening from June 2024. In effect, securities issued by the government of India will now be included as part of the JP Morgan Government Bond Index (Emerging Markets Global Diversified). This has been through a lot of ups and downs over the last 5-6 years when the Indian government had been lobbying with the leading global debt index providers.
The Indian government wanted their bonds included in indices like JP Morgan, FT, and Bloomberg for greater visibility. According to estimates, the inclusion of Indian bonds in these debt indices will result in bond market inflows to the tune of $25 billion to $30 billion, although some analysts believe that the total flow including active and passive flow could be closer to $40 billion. But, first why the delay in including India in the bond indices?
In the last few years, since India started lobbying with index providers for inclusion, there have been several reasons for the delay. Firstly, there was the issue of narrow ownership of government securities and most of the index service providers were wary of including Indian debt in the indices when ownership was narrow and liquidity was concentrated. That is not really an issue now. Secondly, there were concerns that retrospective taxation could be a challenge for inclusion in bond indices and the index providers wanted to avoid that risk.
Thirdly, index service providers were consistently lobbying with the Indian government for special tax concessions for inclusion in the bond indices. The government was not too inclined toward such concessions. In 2022, there was almost an agreement on this subject but the deal fell apart at the last moment after the Indian government stuck to its stand. Another major concern JP Morgan had was that India did not have the ability to handle international debt clearing of that magnitude Now, it looks like most of the irritants along the way have been resolved and the inclusion should happen smoothly in middle of 2024.
To begin with, only central government securities will be included in the bond indices, with private debt and state debt to be considered at a later stage. To begin with, India is likely to be assigned the highest permitted weightage of 10% for its government of India bonds. It is estimated that around 23 government securities would meet all the conditions for inclusion and that means; bonds with a notional value of $330 billion will be included in the index.
Currently, the foreign ownership is just about 2.8% of their total value outstanding, but this is likely to go up sharply once they are included in these indices. Here is how it would work. There are a number of passive funds and debt market index ETFs that invest in the popular JP Morgan indices as a proxy for investing in the debt of an EM. They would infuse funds directly into the index and indirectly into these bonds; boosting volumes in the process.
That is where the biggest advantage of an index inclusion comes in. Globally, there are scores of passive index funds and index ETFs which use benchmarks like the JP Morgan Emerging Markets Bond index to invest in the bond of EM nations. With India getting a 10% weight any allocation to this index would automatically entail 10% allocation to India. That is a lot of foreign flows into Indian debt, imparting greater stability to the Indian rupee due to positive flows from FPIs. Currently, the JP Morgan bond index is tracked by passive debt funds with assets of over $200 billion.
A weightage of 10% would mean $20 billion would come into India by default. But that would just be the beginning as the improved liquidity will also attract other active and long-only bond funds also into the fray. The eventual flows into India would, therefore, get magnified by the inclusion in the index. Ironically, the FPI investments in government bonds is still way below the levels seen pre-COVID so there is a lot of room for investments by FPIs into government securities to pick up in a big way. We have to wait and see how it pans out.
There are some apparent positives for India from this inclusion. Inflows into the government bond market will lower interest costs for the government over the longer term. That will also bring down the overall level of rates in India. But the big story is going to be that it will be a significant pull factor for foreign investments. That is likely to come from the passive funds that benchmark to bond market indices like the JP Morgan Emerging Markets index.
Passive investments into India are growing in a big way in last few years. FPI passive investments in India are already at $78 billion, which is 15% of the total FPI India AUC (assets under custody). Globally, the share of passive investments is already at 30% and India may also be moving towards that figure. The potential through an inclusion in the bond indices is huge. Is it such a simple story, or are there downsides to such flows.
Indian markets are still small by global comparison on bonds and that always makes the Indian market vulnerable to outflows. Bond money can move out rapidly in times of economic crisis, or when rates are likely to go up. Passive funds move in droves and they can liquidate funds in a big way at short notice. We saw such instances during the market crisis of 2013 and later in 2020. Redemption pressure is one more risk that cannot be wished away and can exert a lot of pressure on Indian markets. Empirical studies have also shown that in times of crisis, passive fund outflows are four times as quick as active fund action. But that is par for the course. The bottom line is that the inclusion gives an improved profile to Indian bonds, stabilizes the rupee, and lowers borrowing costs. That is worth a lot!