Mumbai: India’s inclusion in the JP Morgan global bond index promises to do something unprecedented for India’s sovereign debt market: Boost demand beyond the predicted supply. But the anticipated passive fund flows also pose a tricky liquidity-management problem for the central bank that wants to restrain inflation without having to raise rates.
The jury is out on how the Reserve Bank of India (RBI) plans to solve this problem. Some analysts believe the RBI may dust off a toolkit unused since 2017 – of organising standalone large-scale open market sales of sovereign debt. “In FY25, we see demand for G-secs exceeding supply due to index-related inflows. We estimate that demand for G-secs could exceed supply by ₹900 billion (₹90,000 crore), due to inclusion into JPM GBI-EM,” Gaura Sen Gupta, economist, IDFC First Bank, said.
“RBI could address this demand-supply mismatch by OMO sales. As of June 2023, RBI holds ₹13.6 lakh crore in G-secs which consists of both FAR and non-FAR. We estimate that RBI is holding ₹2 lakh crore of FAR (Fully Accessible Route) securities which will be included in the JPM index,” she said. Last month, JP Morgan said that India will be included in the Government Bond Index-Emerging Markets (GBI-EM) global index suite starting June 28, 2024. Only government securities designated in the FAR category – of which there are currently 23 – are index eligible.
Market participants estimate foreign investment worth $20-$25 billion to flow into the Indian government bond market till March 2025, although some analysts have pointed out that the flows could be of a lower order, given the difference between ‘passive’ and ‘active’ funds linked to global indices. While passive funds track global indices and hence represent sticky inflows, active funds do not necessarily flow into such indices.
However, even assuming the lower end of the $20-$25 billion projection, overseas funds worth more than ₹1 lakh crore are seen hitting the Indian market.
Dollar Stash
The RBI is seen absorbing the dollar flows, building up its reserves and then balancing the liquidity impact by draining out excess funds with banks through OMO sales of bonds.
“The RBI will likely continue to use the various instruments in its toolkit, to recalibrate liquidity in line with its objectives on inflation and financial stability. For now, we expect it to keep liquidity tight at a time food prices remain elevated,” HSBC’s economists Pranjul Bhandari and Aayushi Chaudhary wrote recently. “On instruments, we expect it to continue to use temporary tools such as the VRRRs (variable rate reverse repo) and forward book more frequently but could also use the more permanent tools like CRR (cash reserve ratio) hikes and OMO sales if the quantum of liquidity becomes too large, for instance, if entry into several bond indices coincide,” they wrote.The central bank projects headline retail inflation at 5.2% in the first quarter of the next financial year, considerably higher than its target of 4%.
From the RBI’s perspective, absorbing the dollar inflows may also be necessary to rein in potential rupee appreciation to ensure export competitiveness.
In terms of bond market demand-supply dynamics, analysts predict net supply of government bonds worth around ₹12 lakh crore in FY25. State Bank of India sees the net supply of bonds at ₹12.3 lakh crore, while IDFC First Bank predicts ₹12 lakh crore, assuming the Centre sets a fiscal deficit target of 5.5% of GDP for the next year.
“We believe yields could touch 7% even before March of the current fiscal and should affirmatively breach 7% in FY25…demand for G-secs could now outstrip supply of G-sec. This could be a new turning point in the G-sec market in India,” SBI’s group chief economic advisor Soumya Kanti Ghosh recently wrote.
