Explained: Why India's Inclusion In JP Morgan's Emerging Markets Bond Index Matters

India’s inclusion in JP Morgan’s emerging market bond index had been on the books since the beginning of the year since JP Morgan began sounding out investors on Indian bonds’ inclusion.

The inclusion has been in the offing for years with various policies being implemented to attract foreign money into India. A recent major move was the Reserve Bank of India’s launch in 2020 of the fully accessible route (FAR) bonds that were quite popular with investors.

Until April 2023, foreign investors had bought nearly $2 billion worth of FAR bonds – the result of a relatively stable rupee, investor optimism, and higher yields. These bonds account for a little more than a third of government debt, and a large part of new issuances, making them the perfect security for inclusion in JP Morgan’s index.

Currently, foreign investors own two per cent of Indian debt, a number which could more than double after the next inclusion.

JP Morgan had withheld the inclusion last year, after fund managers who track the index had opposed the move due to India’s taxation and supposed lack of market infrastructure. The government had refused several of the investor requests on taxation, listing of bonds on Euroclear and other demands, and wanted the inclusion to happen on terms it was comfortable with.

Unsurprisingly, the investors and index creators appeared to have agreed to these terms, possibly due to India’s resilient performance and tumult in other emerging markets including Russia, China, and several others. Inflation too appears to have been brought under control, and interest rates might not see large increases.

Indian bonds are expected to account for ten per cent of the index, once it is included. The inclusion would result in index tracking managers allocating money to India, which is expected to be in tens of billions of dollars.

Investors, whose immediate reaction has predictably been positive, pushed down yields for a while. However, the yield closed at a higher rate. A lower yield would mean that the government can issue debt at a lower cost, making it easier to service debt.

The government has stepped up its borrowings to fund the massive infrastructure spends. Lower government yields could result in lower yields for Indian corporates as well, which would mean a smaller interest outgo.

More specifically, the financial services sector could be an immediate beneficiary of falling yields, and the rise in bond prices. Banks for instance, hold bonds on their books, and an increase in value of such bonds would add to accounting profits.

However, there is a flipside to such money inflows.

The Indian government and policymakers have been skeptical of foreign money, since such money can often be “hot money”. Offering tax sops, and other incentives could attract a large swathe of money which often flows out swiftly during crisis periods, which could exacerbate troubles.

Hot money’s tendency to move quickly from one country to another in search of profits, can result in a volatile currency rate and potentially cause larger financial issues.

Excessively high foreign currency inflows can also result in appreciation of the rupee, which could make Indian manufacturers less competitive in global trade. The 1997 financial crisis is a prime example of hot money flows derailing economies of emerging markets.

When compared to other emerging markets RBI has usually managed to reign in volatility, and the foreign ownership of sovereign debt is capped at six per cent, which could limit the effects of volatility during tough times.

Indexed money, though, might be stickier since an investor is required to conform to the index. Unless the index weights are changed regularly or the investee funds themselves face redemption, the money is likely to stick around for a while.

The JP Morgan push to include India could help nudge other indices like FTSE-Russel and Bloomberg-Barclays to include India in their indices. So far these indices have not included India due to reasons ranging from India’s refusal to list bonds on Euroclear or not meeting the minimum credit rating required.

China is already a part of the three indices, and has been a recipient of foreign capital for some time now.  Previously, China’s inclusion in the JP Morgan index was followed by inclusion the in the other two passive indices in quick succession. Whether the same scenario is repeated with India remains to be seen.