With bond power, comes great responsibility

It is often said that when stars are aligned, magic happens. They couldn’t have been better aligned for India’s case for its inclusion in the JP Morgan EM bond index.

With Russia’s exclusion and China’s weightage trimming, everything was falling in place for such an inclusion for India.

With a stable macro in terms of fiscal and monetary policy management, it was only a matter of time before this could be sealed.

Given this backdrop, business dailies and business media channels have been flooded with special panels debating the implications for the macro, since the time this grand announcement was made last week.

Needless to say, this move will have hugely positive implications for bond yield, currency and balance of payments (BOP) etc. Our focus in this column is to go beyond this and discuss more on the responsibility and accountability that comes with this great power.

Before delving into that, let us take a brief look at how anticipation of this move by markets has already had a soothing effect on India’s yield and on its currency.

To observe this, one simply needs to examine the recent movements of the dollar index and its impact on our money and currency markets.

The dollar index has an uncanny ability to make the EM currencies dance to its tunes. EM currencies feel pressure when the index firms up and vice versa. Since the end of August, the index has witnessed a very sharp rally on expectations that the interest rates in the US are likely to stay elevated for an extended time.

This view got further strengthened after the Fed Chair’s recent policy pronouncement that it is not done with the rate hikes. The dollar index took cues from there to further shore up its rally. In normal times, this would have a major rub-off effect on both currency and bond markets back home here. But not this time.

Looking at the data points, since the time the dollar index started rallying from around 103 level as of end of August to 106 levels now, currencies have eased, and yields have firmed up across emerging markets.

The currency damage has been from 1% to 1.7% across emerging markets. However, in India, currency and money markets have been resilient with rupee and 10-year Gsec yield holding up well against the pressure from rising dollar index and from firming up of US 10-year yield, thanks primarily to the buying interest (front running) in anticipation of the bond inclusion move by the markets.

Now, let’s shift our focus back to the core theme of this column, the question of responsibility. While much of the media is focused on the quantum of potential inflows that can come into Indian bond markets because of this inclusion move, to address the responsibility question, one needs to look at how the potential outflows during global downturns could derail the macro stability if India mismanages its fiscal and monetary policies during slowdowns.

Imagine that 50 billion dollars come into India over few years because of this inclusion and a quick exit of even a small part of that could be devastating to our money and currency markets if it happens in a disorderly fashion.

That potential event risk can be the biggest check and balance for the Indian polity which has the tendency once in a while to yield to populist pressures.

From this perspective, in our view, this bond inclusion is one of the biggest reforms that could have happened for India, as this will bring fiscal restraint, monetary prudence and judicious current account management etc., to the future political regimes.

Even if India were to have an unstable political formation at the center (coalition regimes) in future, risk of macro instability will act as a huge deterrent for any misadventures from any of the coalition partners.

In other words, this move will put huge responsibility on the future administrations with respect to fiscal and monetary policy management.

As we have seen in the past, ministers in the north block tend to state publicly that they don’t lose sleep over stock-market actions (as one can recall a similar statement in 2019).

While they can get away from such irresponsible statements about equity markets, it will be hard for them to say the same about currency and money markets as it will hit where it hurts the most.

Inflation (feed through effect from unstable currency and interest rates) is a hot button for Indian polity. Anything that hits inflation hurts the common man and as a result, will be a hard pill to swallow for political masters.

Future policy makers will be lot more careful when it comes to fiscal slippages and political largesse. It is hard to find any other reforms (other than probably full capital account convertibility) that will bring such an immense accountability to the future political administrations. From this perspective, it is such a welcome move for anyone who wants to see India opening up to global markets.

Further, bond inclusion is not going to stop with just JP Morgan. It is just a start. With more indices like Bloomberg to follow suit, more accountability and scrutiny are on cards for Indian policymakers. As one research house observes, “Beyond the euphoria of bond inclusion, the index inclusion opens up India’s fiscal situation to a greater scrutiny, with spending quality, efficiency of tax and other receipts collection, and adherence to fiscal consolidation path being closely monitored”. It goes on to add that this move will have

flattening bias for the yield curve and an appreciation bias for the currency.

In summary, if the increased accountability and heightened scrutiny lead to the much-needed fiscal restraint and prudent monetary management, India's macroeconomic prospects are poised to shine even more brightly in the years ahead. It appears that the stars are aligned favorably for India, and we are indeed entering into exciting times!