India’s inclusion in bond indices may be delayed

For the past few months, there has been aggressive buying in Indian government paper by many foreign investors and domestic participants. This is ahead of the expected inclusion of the Indian government bonds in the global indices like the JP Morgan Bond Index and the FTSE Bond Index. The inclusion of Indian bonds was supposed to infuse $30 billion of funds into Indian bonds. The expectation was that with the current sanctions against Russia, the major bond indices would replace Russian bonds with Indian bonds in the index. That was something that India had been lobbying with the major index providers for some time now.

However, in a recent statement, the Indian government on Wednesday, ruled out any changes in tax policies that would have made it easier for Indian government bonds to be included in global indexes. The index providers were asking for capital gains tax waiver on these bonds, but the government has refused to give any waiver on capital gains tax, suggesting that FPIs should pay tax just like any other investor in bonds. Also, the government has been concerned that such tax waivers (apart from loss of revenues) would also result in too much of hot money flows causing bond market volatility.

These taxes had been the stumbling block for a long time and with the government refusing to ease on the tax front, it looks like the inclusion of Indian bonds may be possibly put off to the next year 2023. However, we have to wait for the final announcements. Both, FTSE Russell and JPMorgan Chase are likely to unveil the results of their index reviews in the next few weeks, when it will become clear whether Indian bonds are going to be included in the index or not. However, if that does not happen, it could lead to a bout of selling as the investors who had latched on to the bonds ahead of the inclusion may look to exit.

Most of the global investors admit that India is the only trillion dollar bond market that is still not included in the global indices. The capital gains tax was the stumbling block, but now it looks like the government would not go out of the way to woo these index service providers to include India in the bond indices. Whether the index service providers like FTSE Russell and JP Morgan Chase look at the logic of the diversification argument to add Indian bonds to the index remains to be seen. If they still insist on capital gains as the “make or break rule”, then the bond inclusion in the index may not happen in 2022.

In fact, one of the reason for the fall in bond yields in India in the last few weeks was that investors were piling on to Indian bonds in the hope that it would be soon included in the index. That had increased the demand and hiked prices of the bonds, pulling down the bond yields in the process. It is also estimated that if the bond inclusion does not happen, then the selling of the bonds could again lead to a spike in bond yields in India. That is not a great feeling as it would not only impact the borrowing cost of the government but also lead to an increase in the borrowing cost of other corporate borrowers in the bond market.

However, the institutional investor opinion appears to be in favour of inclusion of Indian bonds in the index. A recent investor survey conducted by JP Morgan found that most of the global funds want India to replace Russia in the bond indices. However, the caveat in the survey was that most investors would be happy if India would be more flexible and transparent in its taxation policies to avoid any problems in the future. One more factor could be that Indian debt markets still cannot be accessed through international central security depositories like Euroclear, which is something most funds would prefer.

Most passive bond investors rely on such popular bond indices like JP Morgan and FTSE Russell to allocate monies, rather than taking an active bond view. That is the big money and would only come in after Indian bonds are included in the index. However, one risk for the government is also that such a move would make the rupee more volatile and they are already grappling with the rupee in the vicinity of 82/$. For popular trading, the bonds need to be part of Euroclear and for that the capital gains tax have to be waived. For now, it looks like Catch 22 situation.