India Renews Efforts For Bond Index Inclusion, But Barriers Exist

Asian financial services group DBS says India’s new vigour in efforts for its sovereign bonds to be included in global bond indices is encouraging. And, while it is optimistic that Indian securities could enter bond benchmark indices by the second half of 2022, some lingering issues need to be addressed, experts say.

DBS, in its report “India: Setting the stage for bond index inclusion,” said four recent developments in domestic bond markets had convinced them that winds are blowing strongly in this direction.

“The narrative from the Reserve Bank of India and the government has been encouraging in recent months, pointing to a renewed vigour in inclusion efforts, (while) clearance of existing investment hurdles will pave the way for index investors, likely in 2H22, with flows to partially front run the inclusion,” the group said.

Foremost was the creation of the Fully Accessible Route (FAR) channel in 2020, which is a carve-out of government securities and fully open to the foreign investors (free of limits) – via a combination of existing bonds, as well as newly issued 5-year, 10-year and 30-year papers since this year.

The recent Moody’s-upgrade of India’s rating outlook to stable from negative, affirming the BBB- rating, was the other notable development, as is the government’s ongoing discussion with Euroclear – the world’s biggest bond settlement system – to enable the settlement of Indian government securities on the platform.

Finally, global index FTSE Russell’s move in March to place India on the Watch List for potential reclassification of its Market Accessibility Level from “0” to “1”, and the intention to include the country in the FTSE Emerging Markets Government Bond Index (EMGBI) as part of its semi-annual country classification, was another “important step for India’s securities to be considered for eventual inclusion into a global index,” DBS said.

Hurdles Still Exist

Yet, while these developments augur well for India, some barriers still hinder the country’s inclusion in global indices, experts say.

Freezing the Withholding Tax

Freezing of 5% withholding tax on interest earned by foreign investors from local debt papers is one, according to Teresa John, Lead Economist at Mumbai-based stockbroking company Nirmal Bang.

“Global investors, want an assurance that the tax if not removed, wouldn’t increase at least,” she says.

Consistent Taxation Policies

Foreign investors are also concerned about India’s regular revision – since 2016 – of double taxation avoidance arrangements (DTAA) with all international jurisdictions to give the government a greater right to tax foreign investors.

Global indices managers have started insisting that India should expand its Bilateral Investment Promotion and Protection Agreements (BIPAs) with all countries it has DTAAs with, sources say.

BIPAs are agreements between governments of two countries for promotion and protection of investments in each other’s territories by individuals and companies situated in either state.

Capital Account Convertibility

Although India has been trying for inclusion in global indices since 2019 with its first overseas sovereign bond, global investor interest in such papers had been lukewarm due to lack of capital account convertibility – the ease with which the rupee can be converted into another currency through global exchanges.

“The lack of full capital account convertibility stymies our foreign clients, which is also an impediment in the context of participation in global indices. And, I do not think full convertibility is going to happen anytime soon,” said Mumbai-based Veena Sivaramakrishnan, a partner at Shardul Amarchand Mangaldas, a law firm that advises foreign investors.

Shallow Bond Market

While India is touted as one of largest emerging market economies, with a borrowing plan of $1.6 trillion for the 2021 fiscal year, over 80% of its sovereign debts are held to maturity by domestic financial institutions like banks, mutual and pension funds, as well as state-owned financial services companies. Foreign investors are only allowed to hold about 15% of outstanding sovereign bonds ($10.4 billion as of August 9, 2021) each half year, which makes its sovereign debt markets ‘too shallow’ for foreign investors, Teresa John said.

“Indian authorities need to address all these issues but, to my knowledge, I haven’t come across any indications to believe that the authorities are working on them,” Sunil Gidwani, a financial services partner at Nangia Andersen, a tax consulting and advisory firm in Delhi, said.

Draw Factors

Nevertheless, for foreign investors India’s near-term strong recovery in multiple sectors to pre-pandemic levels (see chart), and improving vaccination rates are key draw factors.

“Notwithstanding base effects, the economy will be fastest growing major economy this year, before returning to 6-7% annual growth subsequently,” the DBS report said.

Benchmarks like the JPM Global bond index EM and Bloomberg Barclays Global Aggregate Bond index, are likely to be considered for a start, DBS expects.

That could potentially attract “a cumulative $20-25 billion (of inflows right after inclusion), which can rise further if non-FAR securities are considered over the coming years,” the report said.

• By Indrajit Basu