A WAVE OF passive capital flows is the handsome prize for countries that secure a place in major bond indices. That prospect seems to be on the horizon for India. Many analysts expect part of its government-bond market to enter indices compiled by Bloomberg, a data provider, and JPMorgan Chase, a bank, as early as next year, or perhaps 2023. The government has been keen on inclusion even as it has been ambivalent about other types of capital flows. Its cautious approach is increasingly in line with economists’ shifting attitudes. The flows that inclusion in major bond indices tend to generate are one of the least objectionable forms of international investment. They tend to come from massive, slow-moving funds—the opposite of the flighty hot-money flows that emerging-market policymakers fear. That might be why index inclusion has been a priority for India’s finance ministry. Until last year a cap of 6% on the foreign ownership of government bonds had been the main factor preventing India’s inclusion in the big bond indices. Then officials introduced a “fully accessible route” for overseas investors, which lifts the foreign-ownership limit on some bonds. Analysis by big investment banks suggests that re-weighting by global investors would prompt flows of $30bn-40bn into India’s bond market. That would exceed the current stock of foreign investors’ holdings, which amounts to a mere 2% of the more than $1trn in outstanding Indian government securities. Reliable and regular inflows of foreign capital could help suppress public-borrowing costs. Corporate borrowers could also benefit from lower benchmark rates. And the rupee would be bolstered, according to analysts at Morgan Stanley, a bank. The hope for India, and many other emerging-market governments, would be to mimic China’s experience. Foreign ownership of its central-government bonds has more than doubled from 4.5% to 10.6% in the past four years, without any noticeable hiccups, and without jeopardising China’s broader capital controls. But other countries’ experiences show just how unusually benign that is. India’s own recent relationship with portfolio-investment flows explains the government’s hesitation in opening up fully (ownership caps will remain on other bonds and assets). Sizeable outflows from foreign-bond investors occurred in 2013, 2016 and 2018, all driven by expectations of tighter policy from the Federal Reserve. The 2013 sell-off in particular was combined with a sharp drop in the rupee. Foreign bondholders likewise rushed for the door at the onset of the pandemic last year. Even the IMF, once a stalwart opponent of capital controls, is more equivocal these days. Last year the fund’s Independent Evaluation Office noted that the views of India’s authorities and the IMF on capital controls had become more aligned (although the fund is still happier with allowing large exchange-rate movements in response to external shocks than is the typical Indian policymaker). Nor is the capital that comes with index inclusion entirely stable. Although inflows triggered by inclusion are far less sensitive to the domestic economic environment, they are between three and five times more sensitive to global financial conditions, suggests IMF research published last year. Investors often trim their allocations to riskier emerging markets and retreat to safer assets like cash and American Treasuries during times of market stress. The fact that Indonesia was part of indices constructed by Bloomberg and JPMorgan, for instance, did not stop foreigners selling off its government bonds in the panic of spring 2020. Foreign ownership of the country’s bonds had declined to 21% in October this year, from 39% in December 2019. Research by the Asian Development Bank also finds that foreign ownership of local-currency bonds can increase the volatility of capital flows, particularly in the least developed markets. Still, international institutions are hardly advocating stopping inflows altogether. In a report earlier this year the Bank for International Settlements, a club of central bankers, argued that deep and liquid financial markets, prudent monetary and fiscal policy and strong company balance-sheets could act as buffers against the sometimes volatile ebb and flow of capital. If India is to realise the full benefits of inclusion, it will have to heed that counsel. ■
