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The hurdles in the long road to India's entry into global bond indices

Illustration by Binay Sinha
Early this year, Indian officials were quite sanguine that the long road to enter the global bond indices had finally ended. There was a reason for the mutual congratulations. It was now almost one year since March 2020, when discussions with the managers of three of the most prominent indices had been almost sealed. 

India wanted to be part of some of these indices for a very good reason. Every year pension and insurance funds park trillions of dollars in these indices as passive investors. Flow of investment into debt papers, largely sovereign ones, happen as per the allotment model followed by these indices. So papers that figure in these indices do not need to try hard to become the favourite of these pension and insurance funds. It happens almost automatically. 

The government of India (GOI) papers so far have enjoyed impeccable credentials to join these indices. The Indian government has never failed to honour its debt, the inflation levels in the past few years once the FIT regime came in has been within bounds. Yet the reasons why India has not been in the league had to do with the conservatism of the government. There is a cap on how much foreign investors can invest in these funds and since India does not offer full capital account convertibility, investors rank GOI as having limited liquidity. The other advantage of the GOI papers till March 2020 was they were in short supply. Despite the limited liquidity, the papers would be subscribed the day RBI floated them. 

Quest for foreign money:

All these markers were to change, however, with the onset of the Covid pandemic. First of all, it meant the government and regulatory agencies such as RBI and Sebi were kept too busy keeping the stock and currency markets functioning normally. It was a difficult exercise. The other was there was going to be a highly expanded supply of these papers to finance the reconstruction of the economy. 

In Budget 2019, finance minister Nirmala Sitharaman, who presented it after the general elections, announced plans for India to float a sovereign bond abroad. “The Government would start raising a part of its gross borrowing programme in external markets in external currencies,” she said. Sitharaman justified it noting that India’s sovereign external debt to GDP was among the lowest globally at less than 5 per cent. Opinion from the financial markets and from independent experts soon disabused her of this notion. 

After some months, and with the departure of finance secretary Subhash Garg, who was seen as the architect of the plan, the ministry came up with a more realistic plan. India will instead seek to list GOI papers in global bond indices. These indices include investment grade and government bonds from around the world with maturities greater than one year. They are built as market weighted index of papers from global governments, government companies, corporate and securitised fixed-income investments, but all with maturities of at least more than a year.

There were two triggers to this project. India certainly needs a lot of foreign money to finance its ambitious National Infrastructure Pipeline. The expected spend on it is over Rs 115 trillion over the next five years. The other is how China has moved into the league of global bond markets. Beijing, too, has not floated any sovereign issue, yet backed by its vast economy, it has set out a programme to list papers floated by its government companies in these global indices. It began exploratory work in 2017 and by 2019 had already got listed in more than one. In In 2018, one of the most popular such, Bloomberg Barclays Global Aggregate Index announced it would gradually phase in Chinese renminbi denominated government securities over a 20 month period commencing from April 2019. To sweeten the deal, Beijing announced that coupon interest income received by foreign institutional investors in China bond market will temporarily be exempted from corporate income tax and value added tax for three years.  

As on February 28, 2021, the Index has 23 country papers with China’s weight third at 7.23 per cent, just behind the US at 36.22 and Japan at 14.13. It means all funds that put their money into this index allocate their buying as per this ratio. Indices such as these are, therefore, powerful magnets to draw money into respective government papers. 

Earnest effort: 

Indian government officials began an earnest effort to make GOI papers make the draw. The paperwork included doing a series of know-your-customer compliances to qualify. But the biggest obstacle was that India does not offer full capital account convertibility on the Indian rupee. Also, there is a cap on how much foreign investors can invest in GOI papers. It was raised to 15 per cent in Budget 2020 from six per cent of the outstanding stock. Taken together, it meant liquidating a GOI position was not automatic. While there has never been a case of the Indian government defaulting on meeting redemption pressure on its papers, passive investors were not convinced without a written commitment. Like China, the budget also announced a range of tax rebates like a lower rate of withholding of 5 per cent for interest payment to Foreign Portfolio Investors on bonds issued by Indian companies and government securities. 

The Covid pandemic created the first problem. In April, RBI walked back on raising the limit on foreign investment to 15 per cent. It said for financial year 2020-21, the limit would continue. However, soon after, it issued a new “fully accessible route” for GOI papers. Under this route, foreign investors could load or offload any amount of paper. The only constraint was that the papers had to be designated by the RBI. To make it attractive, RBI designated two stocks maturing in 2024, two in 2029 and one security maturing in 2049 with a potential investment of close to $58 billion. The list is to be updated regularly. Discussions with the bond managers, suspended since March, resumed. The bond managers had also obtained feedback from their investors, who were apparently assured by the RBI route and the KYC paper work done by the finance ministry. 

By October last year, senior government officials said they were hopeful that the process would be completed in another nine months. By July, Indian papers should become a part of the indices. The deadline still stands.

But after India has complied with setting up all the compliances, the bond managers have sent in a fresh set of compliances. While there was queries on taxation earlier too, for instance, what would be the applicable rules for the bonds India would park for the global indices, but there were more this time. 

The new demands raised by the indices managers are that Indian government debt papers should be made part of international central securities depositories, like Clearstream. This will mean the tax treatment on these papers. like the lower withholding tax, shall need to be frozen by India. The government will essentially need to give a commitment that these will not be changed to the  disadvantage of the investors in these funds.

The international central securities depository rules were drawn up by the European Commission in 2012. The clean up is meant to harmonise the way each security is constructed so they could be traded easier. The rules put upon the issuer the obligations to dematerialise the traded securities and offer a uniform settlement period for their transactions. So while an index can be constructed by any financial entity, the securities depository offers an attractive platform to settle the trades in the indices. 

A pension fund in the US or in Sweden will go through the same process offered by the securities depositories when they wish to trade in any papers that feature in an index. The European Central Bank has subsequently come up with fresh guidances for collateral and liquidity management like the one in 2014. The reasons why the European benchmarks have got accepted is because most of the leaders in the business of security depository like Clearstream, Euroclear, SIX SIS are based in Europe. An exception is the US Depository Trust Company. 

Indian officials are unsure of the reasons for the fresh demand by the managers of the global bond indices. They feel that the bad press India has received on its tax laws has made the investors jittery. India is fighting adverse tax awards by international arbitration tribunals in cases like those of Cairn Energy and Vodafone. While the content of those awards has little in common with the fresh demands made by the fund managers, government officials are willing to link the two. These international depositories offer a triangle of harmonised legal environment and jurisdictions and contractual rights for the investors. In other awards if there is a tax dispute of any fund house with the India government, it shall be settled by an arbitration panel. In other words India shall be bound by such rulings, something it has steadfastly refused to do till now. 

This would raise particularly ticklish issues. To bring the compliance regime India offers at par with most OECD countries whose papers are part of these indices, New Delhi may need to sign some new double taxation avoidance agreements (DTAA). India has extensively revised its DTAA templates over the past few years replacing them with a Bilateral Investment Promotion and Protection Agreements (BIPA) and this demand is like walking back on those. The government now needs to examine the alternatives possible to join the international central securities depository networks without having to cede tax sovereignty. This has the potential to considerably delay India’s entry into the global bond indices putting the massive exercise India has held for the past two years with indices like Bloomberg Barclays Global Aggregate Index and JP Morgan GBI EM index, among others.


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