In September 2023, J.P. Morgan unveiled its plan to include Indian local currency government bonds (LCGBs) in its Government Bond Index-Emerging Markets (GBI-EM) Global index suite, set to become effective from June 2024. This announcement heightened expectations across the Indian financial landscape, prompting anticipation from other influential index providers such as Bloomberg-Barclays and FTSE Russell. About four months later, on January 8, 2024, Bloomberg Index Services mirrored J.P. Morgan’s move by proposing the addition of India’s “fully accessible route (FAR)” bonds to the Bloomberg Emerging Market Local Currency Index, set to take effect in September 2024. The spotlight now turns to FTSE Russell, which, in the wake of J.P. Morgan’s revelation, declared India’s retention on its watchlist for a potential upgrade, emphasising the call for reforms in the government bond market anticipated by global investors.
A process that began in 2019
India commenced the process of incorporating its government bonds into global indices in 2019. As a part of this initiative, by 2020, a segment of government bonds became officially accessible to foreign investors without constraints, thanks to the introduction of the FAR. Despite encountering delays linked to the government’s stance on capital gains taxes and local settlement, the fundamental policy remained unaltered. While negotiations are expected to continue, the recent moves by J.P. Morgan and Bloomberg indicate a potential inclusion of the Indian LC government and corporate bonds in more benchmark indices.
In October 2022, a report by the Inter-Departmental Group (IDG) of the Reserve Bank of India (RBI) detailed efforts to internationalise the rupee, particularly by integrating Indian LCGBs into global indices. The document outlines various benefits, including diminishing dependence of public finance on domestic institutions, thanks to access to large international resources and a greater stability of funds tracking indices compared to other portfolio inflows. While recognising potential risks such as heightened sensitivity of domestic monetary and financial conditions and policies to external factors, the report asserts that the perceived benefits outweigh the risks.
Several observers have also pointed out that opening local bond markets would facilitate the financing of current account and fiscal deficits by engaging institutional investors with long-term investment horizons. Furthermore, it is argued that the cost of public borrowing would decline as the influx of funds into LCGBs lowers domestic interest rates. It is also expected that these funds would relieve the balance sheets of local financial institutions holding LCGBs, thereby increasing lending and private investment.
A key benefit of opening local bond markets to foreign investors emphasised by the mainstream, relates to the so-called “original sin” problem — that is, the inability of emerging economies to borrow internationally in their own currencies. Unlike local currency debt, external debt denominated in reserve currencies exposes debtors to the exchange rate risk. In times of sharp currency declines, this exposure could result in widespread private insolvencies and large public deficits — as seen in various instances of crisis in Asia, Latin America and elsewhere.
By opening bond markets and borrowing in local currency, the exchange rate risk is passed onto international lenders. However, this does not come free. It needs to be compensated. Furthermore, since these bonds are generally subject to domestic jurisdiction, lenders also face an additional default risk. This also needs to be compensated.
Thus, local currency bonds need to offer higher returns than forex bonds issued under foreign jurisdiction — in higher interest rates and/or capital gains. Indeed, even when large international investment in local bonds of emerging economies made after the global crisis in 2008 helped reduce local interest rates, the bond index in local currency terms outperformed the index in U.S. dollars, thanks to large capital gains from currency appreciations.
Loss of autonomy, greater risks
The internationalisation of bond markets in emerging economies also entails a significant loss of autonomy in controlling long-term rates and exposes them to greater interest rate risks. When global risk appetite and liquidity conditions deteriorate, and access to international capital markets is impaired, domestic bond markets too can get crippled due to adverse spillovers. This was seen after the Lehman collapse in September 2008 and when the US Federal Reserve revealed its intention to start reducing its bond purchases in May 2013. Again, after the recent normalisation of monetary policy in the U.S., local bond rates in emerging economies also shot up and continued moving with shifts in investors’ assessment of the possible course of policy stance of the Federal Reserve.
There is a misconception among proponents that foreign portfolio inflows into local currency bond markets (LCBM) provide stable and long-term funding. Unlike sovereign bonds of main reserve-currency countries such as the U.S. Treasuries, local currency sovereign debt of emerging economies is not held by central banks as international reserves, but fickle investors, primarily money managers from advanced economies, holding liabilities in their home currencies. As the adage suggests, everyone is a long-term investor until they recognise the impending end. When apprehensions emerge regarding short-term capital losses, be it due to rising interest rates, local currency depreciation, or a combination of both, stability tends to dissipate swiftly.
With the move to floating and increased exchange rate volatility, local currency bond inflows to emerging economies have become increasingly volatile because of the exchange rate risk borne by investors. There are significant variations over time in the share of foreigners in local bond markets and several instances of sudden stops and exits. In Malaysia, during 2014-15, the rapid exit of investors from local currency assets, including bonds, resulted in large reserve losses and sharp declines in the ringgit, pushing it to below the levels seen during the Asian crisis. In Türkiye, where macroeconomic imbalances were much more serious, foreigners totally left the bond market after Spring 2018, and reserve losses and currency declines were aggravated as unhedged local forex debtors joined in to avoid exchange rate losses.
In times of market distress, external debt in local currency plays a greater role in the drain of reserves and currency declines than forex debt because of investors’ exchange rate risk. Indeed, evidence shows that the volatility spillover for local currency bond funds is significantly larger than that for reserve-currency bond funds.
As per the October 2022 report from the IDG of the RBI, the opening of the LCBM to foreign investors and the inclusion of Indian LCGBs in global bond indices represent just one facet of the broader effort to internationalise the Indian rupee. Another crucial element involves permitting banking services in the rupee INR outside the country. The case of settling trade with Russia in the Indian rupee for crude oil resulted in an accumulation of the rupee in Russian banks.
Additionally, as reported by Bloomberg, the RBI has granted authorisation to 17 banks to settle trade in the Indian rupee across 18 countries and establish 65 offshore deposit accounts. This effectively creates an offshore INR market and introduces new avenues for speculation and potential instability, in addition to opening the LCBM to foreign investors.
The Malaysia and Türkiye experiences
Malaysia’s experience during the 1997 Asian crisis serves as a notable example. Many of the woes of the Malaysian economy during that period were due to the offshore ringgit market in Singapore. As market confidence waned alongside the broader regional downturn, currency traders in the offshore market engaged in speculative activities in anticipation of a substantial devaluation. Offshore ringgit interest rates surged, exerting upward pressure on domestic interest rates, deepening downturn, exacerbating outflows of ringgit funds and compounding banks’ liquidity challenges and overall financial distress. The Malaysian authorities could only regain control after effectively closing the offshore ringgit market in September 1998 through the implementation of capital controls. Again, more recently in Türkiye in 2022, the offshore lira market in London became a major source of speculation against the Turkish currency, and the government took measures to curb it, including restrictions on bank lending to firms trading liras offshore.
As Y.V. Reddy, a former Governor of the RBI, writes in his article for The India Forum (June 2023), experience indicates that “currency internationalisation cannot be decided in one day and pursued the next. It comes about after a long evolutionary process, when all the building blocks are in place”. He also points out that the Indian rupee is yet to be regarded as an international currency and its internalisation is “likely to be more an outcome of sustained development of the financial system and improved economic performance”.
To sum up, the internationalisation of bond markets and currencies of emerging economies is often presented as a recipe for overcoming the consequences of the original sin, enhancing the resilience to external shocks and improving the volume and allocation of investment. This is also encouraged by international investors and financial media which see large profit opportunities in unhindered access to markets of these economies, as is the case with India now. However, the risks involved are seriously underestimated. Given the inherently unstable international financial markets, a more likely outcome of such a step would be increased exchange rate instability and boom-bust cycles in capital flows. After several episodes of crisis in emerging economies, we should all know by now that when policies falter in managing financial integration, there is no limit to the damage that international finance can inflict on an economy.
Yılmaz Akyüz is a former Director at the United Nations Conference on Trade and Development, Geneva, and the author of Playing with Fire: Deepened Financial Integration and Changing Vulnerabilities of the Global South. T. Sabri Öncü is a former Head of Research at the Centre for Advanced Financial Research and Learning (CAFRAL), Mumbai and a former Senior Economist at the United Nations Conference on Trade and Development, Geneva
