A version of this article was first published on FinanceAsia.
The much-awaited inclusion of Indian debt in JP Morgan Government Bond Index Emerging Markets (GBI-EM) faces further delay.
Initially expected to be announced in September, this is now unlikely to be confirmed before the new year, and it remains unclear how issues around capital gains tax and settlement will be resolved, experts told FinanceAsia.
“Initial concerns included the rupee’s partial capital account convertibility and limits on foreign ownership of Indian debt. China doesn’t have a fully convertible currency so this is not a necessary condition for inclusion, and foreign ownership limits on Indian government debt have now been removed for certain bonds, so the real problem remains capital gains tax on Indian bonds,” explained Sujan Hajra, chief economist and co-head of research at local financial services firm, Anand Rathi.
Investors in Indian securities are subject to long- and short-term capital gains tax, which can amount to 30% if the securities are sold within one year. This has not come in the way of foreigners investing in equities, Hajra said, but those behind mainstream bond settlement platforms such as Euroclear, insist that India should do away with capital gains tax in order to better align with international policies and practices.
A tax waiver would be necessary to enable settlement in the market via Euroclear, but India has so far been unwilling to make any concessions.
“India’s view is that it is levying this tax on all investments, even [those made by] domestic investors, so they cannot give special treatment for foreign investors. That’s why the inclusion [in the index] remains delayed,” said Hajra.
At the same time, international settlement platforms do not want to face the additional accounting burdens that capital gains tax currently entails, he explained.
While India is keen to have access to this new pool of capital, it does not want to send the wrong signal to domestic investors by offering concessions for offshore investors, reiterated Vivek Sharma, head of the International Clients Group at Edelweiss Wealth Management.
“Allowing a waiver would imply that offshore investors are much more sought after than domestic investors, who have been supporting the market for years,” he told FA.
India could instead push for settlement on local platforms – as is the case for Chinese bonds – but for those foreign investors that are used to carrying out investments on international platforms, this could pose operational challenges, Sharma explained.
Opening up capital markets
India’s inclusion in the GBI-EM index was first proposed half a decade ago, but fears that allowing foreign investment into its debt market would make it vulnerable to volatility and speculative currency trading have meant that it has maintained significant restrictions on debt.
In contrast, the liberalisation of its equities markets began in the 1990s.
“Today, the foreign portfolio holding of Indian debt is less than 2% of its $1 trillion public market capitalisation, whereas 55% of the free-float market capitalisation of equities is controlled by foreigners,” said Hajra.
The experiences of East Asia during the financial crisis in the 1990s further increased India’s aversion to large amount of debt flows, Hajra explained. But over time, with India becoming more stable in terms of external finance – its foreign exchange reserves are one of largest in the world – it has since opened opportunity for foreigner investors to take on exposure to its debt.
The recent experience of Covid-19, and the evident advantages brought about by fixed income investor diversification have also helped the government come around to the idea, said Sharma, who added that the government is now keen to internationalise its currency.
In April 2020, India removed restrictions on foreign ownership of certain bonds under what it called the “fully accessible route” (FAR), allowing Indian companies to raise rupee resources abroad, through Masala bonds (bonds issued outside India but denominated in Indian rupees).
FAR bonds are those most likely to become eligible for inclusion in the index over the short-term.
“Additionally, foreign investors are more open to the inclusion of Indian debt in global indices, so there is a demand driver as well,” Sharma added.
Impact of inclusion
Once included in the GBI-EM gauge, Hajra predicts that India could attract inflows of between $25-30 billion, based on the $250 billion approximate value of funds tracking the index and its expected index weighting of between 9-12%.
Sharma noted that the maximum weighting currently held by markets in the index stands at 10% – as is the case for China and Indonesia – but he said that some estimates suggest India could attract $30-$40 billion.
If China’s experience of the GBI-EM index in 2020 is anything to go by, there could be an initial “euphoria” following its inclusion, Hajra said.
“In its first year of inclusion, China received close to $200 billion worth of non-resident portfolio inflows, well in excess of its weight [in the indices]. In last 12 months, this was around $20 billion, more in line with its index values,” he said.
India’s officials are also said to be in talks regarding inclusion in the Bloomberg-Barclays benchmark.
The wider benefits of India’s inclusion in the indices include developing increased depth in India’s debt market and greater access to capital for Indian corporates.
“Inclusion in this sort of index allows inflows of long-term allocation in the debt market, which may help reduce interest rates in India and ease borrowing cost for onshore borrowers,” said Sharma.
Additionally, access to a new pool of capital means that the India government could ease the high statutory investment requirements it imposes on banks and insurance companies to buy government securities, in order to fund its high levels of government borrowing, Hajra added. India announced plans to borrow a record ₹14.95 trillion ($200 billion) in the current fiscal year at its latest Union Budget.
“Once you create alternative source of demand for government securities, you don’t need to create a captive market, so banks and insurance companies will have greater choice in terms of deploying their funds,” he explained.
Inclusion by 2023
Yields fell in August and September as investors upped their purchase of FAR bonds in anticipation of their inclusion in the GBI-EM index. According to Bloomberg, 10-year rupee bond yields fell around 30 basis points, to 7.33%, at the end of September, at a time when yields in the US and elsewhere began to rise.
It remains unclear exactly how the government will resolve the issue of taxation and settlement, but it is likely that the parties involved will find some “middle ground” in order to push through India’s inclusion by the early part of 2023, Sharma suggested.
Further delay could prompt investors to sell their recent purchases, which could lead to rising yields.