)
Raghuram Rajan, the new Governor of the Reserve Bank of India (RBI) takes office amid an unprecedented rout in the Indian Rupee. Bears suggest the lack of confidence in the currency threatens to feed on itself, potentially creating a vicious circle threatening corporate balance sheets, weakening business confidence, increasing inflation expectations, undermining investment demand and worsening the fiscal situation. Seeing the danger, the RBI has taken the sensible but hard road to stabilise the Rupee by tightening monetary conditions.
But this is tough on the economy as the bitter medicine may have to be administered for a long time to restore confidence in the currency. Fickle investors may even question whether the RBI has the stomach for the fight. What is needed now is a circuit breaker; a catalyst to turn sentiment around to bring about a virtuous circle, of stronger Rupee, lower interest rates, greater business confidence, and better growth prospects feeding each other. The question is how.
The good news is that India has easier options, including some truly exciting opportunities. India’s quota system and the significant administrative burden of opening accounts has meant that bond markets are largely closed to mainstream foreign investors, instead attracting mainly speculative flows into India in pursuit of short-term currency or arbitrage gains. What India needs is a steady influx of high quality flows of long-term dedicated money from large institutional investors looking to diversify away from bond markets in developed economies and take exposure to the long-term potential of the Indian economy, which remains enormous.
To do this, the authorities should consider opening up the bond market and qualify to be included in the major Global Bond indices that dedicated investors are benchmarked against. The maths is simple. The market’s most popular benchmark is the JP Morgan GBI-EM Global Diversified Index, which is followed by approximately $200bn-$225bn of global bond investors, according to JP Morgan.
Given the size of the Indian bond market, it is likely that India would enter the index with a weighting of 10%, which means that the flow into the Indian bond market would likely be at least $20bn over a period of say six to twelve months, assuming investors take a neutral (market weight) position. But this is probably an underestimate. First JP Morgan’s estimate of how much follows GBI-EM GD may be understated; second, investors would probably take an overweight position on India if sentiment changed as we would expect; third, India would qualify for other indices that investors follow, increasing inflows further.
Qualifying for bond index inclusion, triggering around $20-30bn of foreign capital inflows, financing a large chunk of India’s current account deficit, would act as the circuit breaker, helping to stabilise the currency and restore business confidence and creating the necessary conditions for a virtuous cycle to develop.
But there would be longer-term benefits too. It would allow India’s government and corporations to access another segment of global liquidity from long-term fixed income investors; an accessible bond market would improve the transmission mechanism of monetary policy as higher interest rates would attract foreign capital to stabilise the currency. The government would probably be able to increase its debt maturity profile and best of all foreign capital would “crowd-in” private investment as banks would have less capital tied up in bond trading, thus channelling their limited resources on what they should be doing – lending to the real economy.
India’s entry to the mainstream global bond indices can likely be achieved with surprising ease. We think India would only need to make two simple policy adjustments to qualify for index inclusion.
First, India would need to get rid of the quota system altogether. This is a non-negotiable requirement for index inclusion, which requires equal and unfettered access. Removal of the quota system would bring India more in line with trends across the rest of the Emerging Markets, where domestic bond markets have largely supplanted external (dollar) bonds as the preferred way to tap into global pools of institutional capital.
Secondly, because the administrative burden to open up local accounts is so high, India must make settlement of local bonds easier by allowing domestic bonds to be settled in euroclear. As an example, Russia’s recent decision to allow its domestic bond market to be settled in euroclear had material positive effects on government borrowing costs. All else equal, we believe this would put India on the radar for index inclusion in short order.
So if there is such an obvious path to take, why have the authorities not grasped this opportunity before? It is hard to know for sure. But one understandable concern might be the fear that foreign investors would be dominating the domestic bond market and threaten financial stability. We doubt it. Given the size of the domestic government bond market of approximately $550bn, it is unlikely that foreign investors will ever become the dominant contingent. And in any case, foreign investors gaining bigger, albeit marginal, influence in the bond market would be no bad thing, introducing another element of market discipline. In fact, India allows relatively free access to its equity market. We do not believe the empirical evidence supports the view that institutional fixed income investors are less stable than equity investors.
It is challenging for governments to embark on difficult reforms when the economy is under duress. But India’s last major reform efforts also followed a period of significant economic difficulties. Aside from significant long-term benefits that it would bring, opening up India’s bond market would decisively improve sentiment and create the breathing room for India’s government to embark on structural reforms to bring about long-lasting changes to the economy. It really is the proverbial “low hanging fruit”. India’s government and RBI’s new Governor should seize the day.
Jan Dehn is head of research at Ashmore. Tolga Ediz is portfolio manager for emerging markets, Ashmore
