The inflow of foreign capital will slow bond yields to some extent
The Union Budget 2022 is days away and there is speculation surrounding the inclusion of India’s sovereign bond in the global bond index. Some time ago, the RBI Governor said that the process is underway and it should happen in a few months. Historically, India has remained opposed to foreign ownership of the country’s debt. This policy choice was largely driven by our experience with the balance of payments situation in the 1990s. The government opened the corporate sector to foreign capital (via the FDI/FII route) and even the FPI bond Corporate risk was kept elevated, but the RBI continued to take a conservative stance on sovereign bonds. Things have changed now and our foreign exchange reserve is sufficient to withstand the short-term volatility caused by a sudden outflow of capital. The Covid pandemic has reduced revenue generation on the one hand while government spending has increased on the other. The government has resorted to borrowing because other non-tax revenues (such as divestment proceeds or asset monetization programs) are lagging behind the target. The yield on 10-year Indian government bonds reached a two-year high of 6.54% in January 2022. Economic growth is still in the shadow of the pandemic and therefore government borrowing is unlikely to decline by drastically. When the economy picks up and demand for credit picks up, banks won’t show the same appetite for government paper and it looks like yields won’t ease in the near term. A higher return means more outflow for interest payments and thus leaving less for the government to create infrastructure and assets.
The inflow of foreign capital will reduce the bond yield to some extent. However, this influx will lead to an appreciation of the INR and will be detrimental to exporters. This exchange rate movement can be managed by the RBI with its market intervention policies. Despite various concessions and incentives given by the government, private investment is not picking up and the government has to come forward for almost all major infrastructure projects. Domestic borrowing has a direct impact on liquidity which has a direct impact on demand/consumption and inflation. external borrowing should be used only for growth purposes and foreign capital should not be used only to finance the budget deficit. The country’s perception of risk determines buyers’ demand for government papers. The Credit Default Swap spread is generally used to assess the perception of risk on securities issued by the borrower. India’s five-year sovereign CDS spread has steadily declined (after peaking in March 2020 due to Covid-related uncertainty), meaning credit perceptions have improved. India’s sovereign credit rating has remained stable and Moody’s downgrade in June 2020 from Baa2 to Baa3 had drawn strong criticism. Attractive yields on Indian bonds are rewarding for foreign investors even when currency risk is taken into account and therefore demand for these securities is not an issue that policy makers should worry about. There are some areas that need to be clarified by the RBI and the finance ministry before this policy change sees the light of day. Although there is an overall cap of 6% and 2% of outstanding loans for central government and state development loans, respectively, the operational process should be smooth. The tax aspect (both the collection of interest at periodic intervals and capital gains) is important because any relaxation for foreign investors would be detrimental to domestic investors. A concession to foreign investors while taxing the transaction in the hands of domestic investors would go against the principles of equity. This structural change shows a change in mindset and is a welcome step but will need to be carefully monitored after implementation. Courtesy of Dailypioneer
(The author is a chartered accountant, author, and public policy analyst. Opinions expressed are personal.)