Why is it in the News?

There is a serious underestimation of the risks involved in the internationalisation of bond markets and currencies of emerging economies.

Context:

• In recent times, there have been noticeable changes in the global financial landscape, specifically regarding the inclusion of government bonds from emerging economies in global indices.
• It is crucial to evaluate the actions taken by J.P. Morgan, Bloomberg, and FTSE Russell in incorporating Indian local currency government bonds (LCGBs) into global indices amidst these developments.
• Exploring the reasons behind these moves and understanding the potential advantages and risks associated with such initiatives is essential.

J.P. Morgan's Influence on India's Financial Landscape:

• The inclusion of Indian local currency government bonds (LCGBs) in J.P. Morgan's Government Bond Index-Emerging Markets (GBI-EM) Global index suite in September 2023 marked a significant milestone.
• This step not only underscored India's financial stature but also raised expectations within the Indian financial sector.
• It spurred interest from other major index providers such as Bloomberg-Barclays and FTSE Russell.
• Subsequently, Bloomberg Index Services announced in January 2024 that India's fully accessible route (FAR) bonds would be incorporated into the Bloomberg Emerging Market Local Currency Index, further bolstering this trend.
• All eyes are now on FTSE Russell, highlighting the increasing influence and anticipation of reforms in India's government bond market.

What is the Process of Opening Local Bond Markets?

• Opening local bond markets to foreign investors is a strategic move by emerging economies to bolster their global financial integration.
• In India, this journey began in 2019 and gained momentum by 2020 with the introduction of the fully accessible route (FAR).
• Despite facing challenges like delays due to government policies on capital gains taxes and local settlement, the core policy remained unchanged, showcasing a dedication to promoting global financial inclusivity.

Advantages of Internationalising Bond Markets:

• Reduced Reliance on Domestic Institutions: By integrating local currency government bonds into global indices, emerging economies like India aim to lessen their dependence on domestic financial institutions.
  • This diversified funding base can contribute to financial stability.
• Stability in Funds Tracking Indices: Inclusion in global indices can result in a more stable inflow of funds, as funds tracking indices typically have a longer investment horizon compared to short-term speculative flows.
  • This stability can help mitigate volatility in local financial markets, providing a secure environment for both domestic and foreign investors.
• Lower Cost of Public Borrowing: Increased demand for local currency government bonds from global investors may lead to a decrease in domestic interest rates.
  • As a result, the cost of public borrowing for the government can decline.
• Relief for Local Financial Institutions: Higher participation by foreign investors in local bond markets can alleviate the balance sheets of local financial institutions holding these bonds.
  • This increased liquidity may encourage more lending and private investment.
• Mitigation of "Original Sin": Bond market internationalization helps mitigate the "original sin" problem faced by emerging economies, where they are unable to borrow internationally in their currencies.
  • By issuing bonds in their currencies, these countries shift the exchange rate risk onto international lenders, potentially avoiding widespread private insolvencies during sharp currency declines.

Risks Involved with Internationalising Bond Markets:

• Loss of Control and Heightened Interest Rate Risks: Internationalizing bond markets poses the risk of losing control over long-term interest rates, leaving emerging economies more vulnerable to global interest rate fluctuations.
  • This can negatively impact domestic bond markets and overall economic stability.
• Exchange Rate Volatility and Spillover Effects: Increased participation by foreign investors exposes local currency bond markets to exchange rate volatility.
  • During periods of global risk aversion or liquidity challenges, adverse spillover effects can occur, as seen in events like the Lehman collapse in 2008 and recent shifts in U.S. monetary policy.
• Volatility in Inflows of Local Currency Bonds: Instances such as the rapid exit of investors from local currency assets in Malaysia during 2014-15 and the total withdrawal of foreigners from the bond market in Türkiye since Spring 2018 underscore the unpredictability of capital flows.
  • These sudden stops and exits can lead to large reserve losses and currency declines, highlighting the potential for rapid market fluctuations.

Efforts by the Inter-Departmental Group (IDG) and RBI to Integrate Government Bonds into Global Indices:

• Indian LCGBs Integration into Global Indices: The RBI's journey towards internationalization commenced in October 2022 with an Inter-Departmental Group (IDG) report outlining efforts to integrate Indian local currency government bonds (LCGBs) into global indices.
• Diversification of Funding Channels: The inclusion of Indian LCGBs in global indices aims not only to attract foreign capital but also to diversify funding sources, reducing reliance on domestic institutions and tapping into large international resources.
• Stability Enhancement and Investment Allocation: The IDG report highlights the potential benefits of LCGB inclusion in global indices, such as enhancing the stability of funds tracking these indices.
  • This stability can foster a more predictable investment environment, attracting long-term investors and improving investment allocation within the Indian financial market.
• Rupee Internationalization Beyond Bonds: Integrating LCGBs into global indices is just one aspect of a broader effort to internationalize the Indian rupee, as outlined in the IDG report.
  • Another crucial component involves allowing banking services in the rupee (INR) outside the country.

Moving Forward:

• Striking a Delicate Balance: While the opening of local bond markets presents abundant opportunities, it necessitates careful balancing.
  • Countries must balance the attraction of foreign capital with the management of potential risks.
• Drawing from Past Experiences: The experiences of Malaysia and Türkiye offer valuable lessons, emphasizing proactive management of offshore markets to prevent excessive speculation and maintain currency stability.
  • These lessons underscore the importance of regulatory vigilance, timely interventions, and a balanced approach to fostering internationalization while preserving macroeconomic stability.

Conclusion

The process of opening local bond markets marks a crucial stride for emerging economies aiming for deeper integration into the global financial realm.

Recent developments involving J.P. Morgan, Bloomberg, and FTSE Russell underscore the growing recognition of India's financial market potential.

As India embarks on this journey, it must adeptly navigate complexities, carefully weigh risks and benefits, and adapt to the evolving global financial landscape for enduring success and stability.