India’s inclusion in JPMorgan’s bond index needs sober analysis

As soon as the announcement was made on 21 September, expert reactions started pouring in. The first set came from those in the business of selling stocks—brokers, fund managers, finfluencers—and were along predictable lines. The logic offered was this.

India’s weight in the index will grow to 10% by March 2025. The assets under management of this index stand at around $213 billion. Along with this, Indian government bonds are expected to be added to other small indices of JPMorgan as well. So, our bond market should see an inflow of $20-30 billion. This will drive up demand for Indian government bonds, leading to higher bond prices, which will drag down bond yields. The yield on a bond at any point of time is the per-year return an investor can expect to earn by investing and holding on till maturity.

Now, lower yields will let the government offer lower interest on the new bonds it issues. As the interest/yield on government bonds sets the overall interest rate scenario, interest rates across the economy will fall. QED.

The direct effects in economics are always easy to figure out. Also, there are incentives at work. Those in the business of selling stocks prefer lower interest rates because that drives more money into stocks as people look for higher returns. But it’s not as simple as made out. There are several other points that need to be understood.

First, the inclusion happens only towards the end of June 2024 and much can change between now and then. It’s worth remembering that rich-world central banks are still talking about interest rates going up. In fact, as JPMorgan CEO Jamie Dimon recently told The Times of India: “The worst case is 7%.” And if that turns out to be the case, interest among active investors for Indian government bonds may not be that high, given that they would be able to earn high returns by investing in US government bonds without taking on any currency risk—the rupee keeps depreciating against the dollar, eating into the returns of foreign investors. So, for them to be interested, the returns on offer on Indian bonds need to be significantly higher than US bonds.

Second, foreign money coming into Indian bonds can also leave fast. History shows that during a financial turmoil, foreign investors sell bonds issued by an emerging market country faster than you can say Jack Robinson. This can impact everything from the dollar- rupee exchange rate to interest rates to the fiscal deficit of the government. Of course, this is a rare possibility, but possibilities also need to be talked about.

Third, the inclusion will lead to increasing scrutiny of the Indian economy, in particular the public finances of the Centre and state governments. The total fiscal deficit of the Centre plus states in 2022-23 stood at ₹26.4 trillion or around 9.7% of gross domestic product. A Bloomberg report suggests this is the highest among the 20 countries in JPMorgan’s bond index.

Over the years, governments in India have funded themselves through financial repression, with a significant portion of every new deposit coming into the banking system being funnelled into buying government bonds. The same holds true for premiums collected by insurance companies through traditional investment policies. This has ensured that the government’s fiscal condition isn’t scrutinized deeply. If active foreign investors show significant interest in Indian government bonds, that’s likely to change. Increased scrutiny will make it harder for the government to use limitations of the cash-based accounting system to declare a lower fiscal deficit than it actually is.

Fourth, a more diverse set of investors investing in Indian government bonds and increasingly scrutinizing public finances as well as India’s economy could lead the bond market to serve as a much better ‘early warning system,’ helping discipline the government of the day.

Economist Stephen D. King explains how this mechanism works in We Need to Talk About Inflation: “Hungry investors [spend] time prowling… in search of fiscal or monetary weakness. When they [find] it… the relevant bond market [comes] under heavy selling pressure.” This can send the government’s borrowing costs soaring and the country’s currency falling, forcing fiscal discipline upon the government. Of course, this is a possibility and depends on how much interest foreign investors take in Indian bonds over the long-term.

Fifth, all this is likely to make things difficult for the Reserve Bank of India, as it will have to balance its multiple roles as debt manager of the government, managing the dollar-rupee rate and carrying out an independent monetary policy to control inflation.

India’s bond market realizes all this. The yield on the 10-year government bond has actually gone up a few basis points since the announcement was made. If the market were factoring in the likelihood of more foreign money coming in, yields would have fallen. Clearly, the bond market is in a wait-and-watch mode, despite stock market wallahs thinking otherwise.

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Updated: 03 Oct 2023, 11:22 PM IST