Managing flows – Govt’s dependence on foreign funds should be limited

Source: The post is based on the article “Managing flows – Govt’s dependence on foreign funds should be limited” published in Business Standard on 25^th September 2023.

Syllabus: GS 3 – Indian Economy – Capital Market

Relevance: About JP Morgan’s decision to include Government of India (GoI) bonds.

News: JP Morgan’s recent announcement about including Government of India (GoI) bonds in its emerging market government bond index has generated significant excitement in financial markets and the government.

What does this mean for Indian bonds?

JP Morgan’s decision to include Government of India (GoI) bonds in its emerging market government bond index is expected to result in $24 billion being deployed in GoI bonds, as India will have a weighting of 10% in the index.

As more assets track this index over time, the inflow of funds is likely to grow, and other indices may also consider inclusion GoI bonds over time, encouraging even active fund managers to increase allocation to GoI bonds.

What implications does this hold for the Indian economy?

The increase in demand for GoI bonds will reduce the borrowing cost for the government. Lower yields on GoI bonds could also benefit states and corporations by reducing their borrowing costs.

Additionally, the influx of foreign capital can help finance the current account deficit. These inclusions in international indices, which attract passive investment flows, are considered stable.

Moreover, the Reserve Bank of India (RBI) began issuing GoI bonds to non-resident investors via the fully accessible route after a reference in the Union Budget 2020-21 indicated that certain bond categories would be fully open to foreign investors.

What are the risks associated?

There are risks associated with tapping foreign savings to finance the fiscal deficit, even if the debt is denominated in the domestic currency:

Increased volatility in bond and currency markets: Even passive flows can exhibit significant volatility at times of macroeconomic instability. This could lead to heightened volatility in both bond and currency markets.

Upward pressure on the currency: An increased level of debt flows could also put upward pressure on the currency, affecting the competitiveness of India’s tradable sector.

As a result, the Reserve Bank of India (RBI) may need to be more vigilant and intervene in the market to manage volatility.

What can be the way ahead?

First, if the idea is to lower the cost of money, it can be achieved by reducing the general government budget deficit, which will reduce the demand on domestic savings and bring down the cost of money and inflation.

Second, the fiscal deficit is usually higher in India than in its peers, which can crowd out the private sector. Increased foreign investment should not be seen as a way to run higher deficits. Instead, the government should be more disciplined.

Third, India needs to import capital for investment, but it has favored direct equity investment due to its advantages. Any shift from this stance should be carefully considered.