Potential pros and cons of including Indian LCGBs in global bond indices
In September 2023, J.P. Morgan unveiled its plan to include Indian local currency government bonds (LCGBs) in its Government Bond Index-Emerging Markets (GBI-EM) Global index suite, set to become effective from June 2024.
This announcement heightened expectations across the Indian financial landscape, prompting anticipation from other influential index providers such as Bloomberg-Barclays and FTSE Russell.
About four months later, on January 8, 2024, Bloomberg Index Services mirrored J.P. Morgan’s move by proposing the addition of India’s “fully accessible route (FAR)” bonds to the Bloomberg Emerging Market Local Currency Index, set to take effect in September 2024.
The spotlight now turns to FTSE Russell, which, in the wake of J.P. Morgan’s revelation, declared India’s retention on its watchlist for a potential upgrade, emphasising the call for reforms in the government bond market anticipated by global investors.
India commenced the process of incorporating its government bonds into global indices in 2019.
As a part of this initiative, by 2020, a segment of government bonds became officially accessible to foreign investors without constraints, thanks to the introduction of the FAR.
Despite encountering delays linked to the government’s stance on capital gains taxes and local settlement, the fundamental policy remained unaltered.
While negotiations are expected to continue, the recent moves by J.P. Morgan and Bloomberg indicate a potential inclusion of the Indian LC government and corporate bonds in more benchmark indices.
The Reserve Bank of India detailed efforts to internationalise the rupee, particularly by integrating Indian LCGBs into global indices.
The document outlines various benefits, including diminishing dependence of public finance on domestic institutions, thanks to access to large international resources and a greater stability of funds tracking indices compared to other portfolio inflows.
While recognising potential risks such as heightened sensitivity of domestic monetary and financial conditions and policies to external factors, the report asserts that the perceived benefits outweigh the risks.
Several observers have also pointed out that opening local bond markets would facilitate the financing of current account and fiscal deficits by engaging institutional investors with long-term investment horizons.
It is argued that the cost of public borrowing would decline as the influx of funds into LCGBs lowers domestic interest rates.
It is also expected that these funds would relieve the balance sheets of local financial institutions holding LCGBs, thereby increasing lending and private investment.
A key benefit of opening local bond markets to foreign investors emphasised by the mainstream, relates to the so-called “original sin” problem.
The inability of emerging economies to borrow internationally in their own currencies.
Unlike local currency debt, external debt denominated in reserve currencies exposes debtors to the exchange rate risk.
Historical examples like Malaysia and Turkey
Malaysia’s experience during the 1997 Asian crisis serves as a notable example.
Many of the woes of the Malaysian economy during that period were due to the offshore ringgit market in Singapore.
As market confidence waned alongside the broader regional downturn, currency traders in the offshore market engaged in speculative activities in anticipation of a substantial devaluation.
Offshore ringgit interest rates surged, exerting upward pressure on domestic interest rates, deepening downturn, exacerbating outflows of
ringgit funds and compounding banks’ liquidity challenges and overall financial distress.
The Malaysian authorities could only regain control after effectively closing the offshore ringgit market in September 1998 through the implementation of capital controls.
Again, more recently in Turkey in 2022, the offshore lira market in London became a major source of speculation against the Turkish currency.
The government took measures to curb it, including restrictions on bank lending to firms trading liras offshore.
As Y.V. Reddy, a former Governor of the RBI, writes in his article for The India Forum (June 2023), experience indicates that “currency internationalisation cannot be decided in one day and pursued the next.
It comes about after a long evolutionary process, when all the building blocks are in place”.
He also points out that the Indian rupee is yet to be regarded as an international currency and its internalisation is “likely to be more an outcome of sustained development of the financial system and improved economic performance”.
To sum up, the internationalisation of bond markets and currencies of emerging economies is often presented as a recipe for overcoming the consequences of the original sin, enhancing the resilience to external shocks and improving the volume and allocation of investment.
This is also encouraged by international investors and financial media which see large profit opportunities in unhindered access to markets of these economies, as is the case with India now.
Given the inherently unstable international financial markets, a more likely outcome of such a step would be increased exchange rate instability and boom-bust cycles in capital flows.
After several episodes of crisis in emerging economies, we should all know by now that when policies falter in managing financial integration, there is no limit to the damage that international finance can inflict on an economy.
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