Inclusion in emerging market bond indexes will help. But it will require loosening rules,easing caps
The government is reportedly seeking entry to benchmark indexes for emerging market debt. This is a step in the right direction as the currency risk is borne by foreigners when they hold rupee denominated bonds. But to prepare the ground for this move,the government will have to bring substantial changes in the present mechanism and ceilings for rupee bond purchases by foreigners. Currently,restrictions are in place based on asset and investor categories for rupee denominated bonds,both government and corporate. For foreigners to build the required capacity to invest,the dollar cap is the most detrimental,even though this cap has been moved from $1 billion to $30 billion for government bonds and to $51 billion for corporate bonds in recent years. As soon as the cap is hit,business grinds to a halt. This has prevented fixed income investors from seriously engaging with India.
Foreign investment in government dated securities is a tiny fraction of total dated securities. These are rupee securities that would have been held by foreigners for their higher yield as well as for currency diversification. Yet,the complicated rules for purchase,the auction mechanism and reinvestment rules,as well as overall caps,have prevented many an investor from coming in. It was only in April 2013 that Sebi changed the rules and made it easier to invest. The cap of $30 billion,which includes subcaps of $5 billion on investment by sovereign wealth funds and on treasury bills,remains an impediment that will soon pose problems for government rupee bonds to be part of indexes. The best way forward would be to remove the caps,as proposed by a recent Sebi study. The second-best option would be to move to the equity framework with a 10 per cent cap per investor and a 24 per cent cap overall.
While allowing higher investment in rupee denominated bonds,India should also take advantage of the desire of foreign investors to hedge their currency risk. To this end,currency futures markets should be opened up to foreign investors. While it is possible for them to hedge in off-shore markets,it is a loss for India if rupee derivatives trade abroad rather than in India. We lose the opportunity to develop liquidity in domestic onshore markets. The inclusion of India in EM bond indexes could also lead to higher volatility of debt flows. If this impacts the rupee,it is also important that Indian companies and individuals should be allowed to hedge their higher risk and that there exists an onshore deep and liquid currency derivatives market which can help in making balance sheets more resilient.