Policy challenges of India's trek to bond indices

India seems to be taking the first steps towards integrating itself with the global bond indices. Understandably, there is palpable excitement in the financial markets, given the large upside it could result in terms of capital flows. Yet, it is pertinent to get a complete picture of the impact analysis. This will be useful for both the Reserve Bank of India (RBI) and the government in formulating policies. Interestingly, the news of coronavirus and the release of gross domestic product (GDP) data have made such policy construct more challenging. 

It was in 2013, when India was in the throes of the taper tantrum, that the idea of the country joining the global bond indices was first mooted. At that point, the central bank was still in a dilemma. In a post-policy interaction, this is what the bank had to say: “We still have to take a calibrated call because in the recent past we have seen when we have opened up more towards the debt segment, maximum heat has come from debt segment, outflows have been very large, and a lot of volatility has been caused because of this debt segment”. 

In fact, the advantages of debt portfolio capital flows are many for the host country from where they originate, and, hence, there is always a cacophony around India getting included in the bond indices. For example, the advantages of an integrated global financial market with the ageing population in developed economies is that with a rising supply of savings, households can invest in emerging economies and earn a higher return than in the domestic economy. Thus, by encouraging capital mobility, it may be possible to shift a part of the demographic burden on young populations in developing countries favouring ageing populations in developed countries (Attanasio and Violante, 2007). A shift in the demographic burden can, thus, be effectively engineered by a change in ownership pattern of domestic government debt.

Let us now fast forward to the current context. With the global economy thrown into disarray following the outbreak of coronavirus, there has been a sizeable portfolio capital outflow of $2.2 billion, with $1.5 billion because of debt alone. This reverses the positive capital outflow during October 2019 to January 2020 at $5.5 billion. Clearly, if we are willing to get into the bond indices, we must also be careful of the significant volatilities in the financial markets. This could make the job of the RBI more difficult in terms of intervening in the foreign exchange markets, as it could act as a double-edged sword in times of liquidity overhang in the system — as is being witnessed currently. 

If the volatility in the financial market continues for a prolonged period, it could also result in important implications for asset prices, and, hence, the creation of wealth, which can have important ramifications for the conduct of monetary policy. 

There are other important changes that we may have to navigate through. For example, the total supply of G-Secs in FY21 could be close to Rs 10.5 trillion, of which demand of securities from banks (based on statutory liquidity ratio requirements and trend growth in NDTL, or net demand and time liabilities) will be around Rs 3.7 trillion. The insurance sector could subscribe to Rs 3.85 trillion (based on current share). The rest of the amount could be invested by mutual funds, foreign portfolio investment (FPI) and others, with the FPI share at Rs 62,000 crore. 

However, in the current scenario, when the Budget seeks to eliminate tax exemptions on insurance products, the appetite for G-secs from the insurance sector and pensions funds, which are the key players for long-term securities of 15 years and above, can be impacted. This must be compensated by FPI flows. It may be noted that the government is already talking about Rs 70,000 crore of special FPI securities under the bond indices. In case FPI bonds are unable to compensate, then the RBI might have to step in through open market purchases. In fact, the FRBM Act provides for an escape clause where the government can borrow from the RBI to finance its temporary mismatch between receipts and expenditure with the advice of the fiscal council, which,  however, is yet to be set up. In such an extreme case, private placement with the RBI may be the option for meeting increased demand for borrowing. Already, there is demand from certain quarters for the RBI to do open market operations (OMO), despite the liquidity surplus in the banking system being close to Rs 3 trillion in February. 

We believe such demand for OMO, coupled with the recent steps taken by the RBI in undertaking operation twist, LTRO and CRR should also be viewed against the persistent demand weakness in the system. The release of the latest GDP data shows that growth in Q1 of the current fiscal was at 5.6 per cent and has progressively declined thereafter to 4.7 per cent in the current quarter. As this period also coincides with the RBI cutting rates by a cumulative 135 basis points, this possibly changes the narrative of rate cuts stimulating the economy. 

While the RBI under the current dispensation must be wholeheartedly complimented for trying to wade through an impossible web of monetary transmission, adequate liquidity, credit spread and even preventing exchange rate appreciation apart from fighting inflation. It is to be noted that provision of abundant liquidity can also result in policy reversals that might be damaging. 

For example, following demonetisation, market participants became used to getting easy money, and this may have resulted in accentuating the non-banking finance company (NBFC) crisis. Such abundant liquidity also resulted in the calibrated monetary tightening during 2018, particularly when the economy was battered by capital outflow choking off systemic liquidity and dampening animal spirits. We must thus guard against easy money over a long period in the current scenario. The only good thing is that the RBI is currently experimenting with outcome-based liquidity regime. This must continue. 

The writer is group chief economic advisor, State Bank of India. Views are personal

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