The recent announcement of JP Morgan about the inclusion of the Indian government bonds in its Government Bond Index-Emerging Markets (GBI-EM) global index from June 2024 augurs well for the Indian economy. It opens an additional avenue of credit for government borrowing in India, which allows it much more fiscal breathing space. It will also have long-term implications for financial and economic stability.
First and foremost, indexation can mitigate the fiscal dominance prevailing in the Indian economy. In the current state, domestic borrowing is the primary source of credit for the government.
The government frequently borrows from the domestic market by tapping into financial institutions, insurance companies, institutional investors, mutual funds etc., for credit.
It results in crowding out of corporates from the domestic credit market. In an optimistic scenario, the indexation in GBI-EM may lead to an estimated inflow of up to $20 billion. This can provide the government with the credit needed to finance a part of its borrowings.
Breathing space
It can reduce the crowding out effect and allow a much-needed breathing space for the corporates to tap into the domestic market for borrowing.
It can also provide Indian banks with a break from financing the government by buying government bonds. The banks can now focus on their original role of financial intermediation and ensure credit supply to the priority sectors of the economy.
Secondly, the increased demand for Indian Government Bonds in the global market can reduce the cost of capital in the economy.
The day of the announcement of the indexation saw a drop in India’s benchmark 10-year bond yield by 7 basis points to a two-month low of 7.07 per cent in opening trade. In the long run, the reduced yield is expected to pass through to the real side of the economy, promoting investment and economic growth.
Lastly, it can also strengthen the value of the rupee in the global market. The rupee gained 0.3 per cent early to 82.25 per dollar on the day of the announcement.
The caveats
While all seems hale and hearty, there are certain caveats to the indexation of government bonds in the GBI-EM index. It opens the Indian economy to global spillovers. India was protected during the global financial crisis because of its capital control policies, but now it must be sensitive to the crisis prevailing in other parts of the world to protect its economy.
Furthermore, because the fiscal space is financed with foreign capital, the medium to longer end of the yield curve is exposed to the monetary policies of other larger economies, especially the US. In such a scenario, policymakers should be more cautious of the consequent domestic interest rate volatility to ensure financial stability.
India will also face the classic macroeconomic trilemma problem of stable exchange rates, monetary policy autonomy, and capital mobility.
The implied capital openness of the indexation to GBI-EM can tie the hands of RBI in a crisis, which may result in the monetary policy strategy of inflation targeting going for a toss.
Overall, the indexation decision in GBI-EM is a step in the right direction.
Although the indexation has pitfalls during a crisis, macroprudential regulations will play a significant role in mitigating these concerns. Indexation will undoubtedly lead to healthy economic growth if policymakers are cognisant of global spillovers and perception, quick-footed in handling it, and ensuring that macroprudential policies are effectively executed.
Chakrabarti is Assistant Professor, IIM Ranchi, Accounting & Finance Area; Sen is Associate Professor, Jindal School of Banking & Finance,O.P. Jindal Global University. Views expressed are personal