India’s Global Bond Gamble: Unlocking the power of FAR and the currency tightrope

The narrowing yield gap between US and Indian bonds has reduced the appeal of Indian securities.

By V Shunmugam, Mohammed Reyhan and Ganesh Prabu

India's inclusion in major global bond indices, such as JP Morgan's Emerging Markets Bond Index, has spotlighted the country in global finance. This strategy is centred on the Fully Accessible Route (FAR), which allows foreign investors unrestricted access to certain Indian government securities. This move attracts billions in foreign capital, enhances market liquidity, and lowers borrowing costs for India. However, risks exist, highlighted by the rupee's slide towards ₹84 against the US dollar, exposing vulnerabilities in deeper financial integration. Recently, Indian sovereign bonds eligible under the FAR have seen their first significant outflow since joining JP Morgan's index, with foreign investors selling ₹1,680 crores ($200 million) in bonds. This was the largest outflow since May, driven by rising US Treasury yields and expectations of sustained high interest rates by the Federal Reserve. The narrowing yield gap between US and Indian bonds has reduced the appeal of Indian securities, showing the fragility of India's integration with global bond markets.

The Fully Accessible Route: A New Era for Indian Markets

The Fully Accessible Route (FAR) introduced by the Reserve Bank of India (RBI) in 2020 aimed to deepen India's connection to global financial markets by allowing unrestricted foreign investment in select government securities. This move attracted significant foreign portfolio investments (FPIs), promising lower borrowing costs, increased foreign exchange reserves, and essential liquidity for bond markets.

However, recent outflows from FAR bonds due to rising US Treasury yields indicate a long-term challenge. As the yield gap narrows, foreign investors may shift capital to safer US securities, leading to potential volatility for India as it strengthens ties with global bond markets. Policymakers must develop strategies to manage this foreign capital flow.

Currency and Interest Rate Pressures

The recent decline of the rupee to ₹84 against the US dollar illustrates the pressure that foreign capital flows place on India's currency. Although the rupee's depreciation has been relatively controlled so far, it reflects the influence of global interest rate differentials and investor sentiment. As US monetary policy tightens, the rupee may face even greater pressure if outflows from Indian bonds accelerate, highlighting the connection between currency stability and capital flows.

Lessons from Other Emerging Markets

India faces global bond market challenges similar to other emerging markets. When China joined the FTSE WGBI from 2020-2021, it saw $130-160 billion in foreign inflows. However, rising US interest rates and geopolitical tensions caused major outflows, pressuring the yuan. Mexico experienced a similar trend after joining JP Morgan's GBI-EM, attracting strong early inflows but enduring significant outflows and a 15% peso drop during 2020's market turmoil.

Managing Volatility and Building Resilience

India must adopt a multi-faceted strategy to leverage foreign capital while managing risks. Its foreign exchange reserves, covering about 97.4% of external debt, are the first line of defense. Strengthening these reserves is crucial for protecting the rupee from volatility. By fortifying reserves, the RBI can support the rupee during foreign capital outflows, lessening domestic market impacts and sharp currency depreciation risks.

Maintaining liquidity in India's bond markets, especially in the FAR segment, is essential. High liquidity enables smooth trading without significant market imbalances. Encouraging domestic investor participation is critical for creating a resilient bond market that can handle fluctuations in foreign capital flows.

Policymakers and the RBI must closely monitor the impact of US interest rates on capital markets and the rupee. The RBI must balance India's independent monetary policy with the need to respond to global financial conditions. Historically, India has maintained an independent stance; however, the FAR route and inclusion in global bond indices necessitate monitoring US monetary policy, as decisions made by the Federal Reserve will increasingly affect India's currency and capital flows.

The FAR Route: Strategic Gamble or Growth Catalyst?

India's decision to liberalize its bond markets via the FAR route reflects a bold and strategic initiative. This pathway presents prospective advantages, including diminished borrowing costs, improved liquidity, and closer integration with international financial markets. Nonetheless, the recent outflows indicate that the FAR route also subjects India to volatility in global markets.

In light of the Federal Reserve's ongoing interest rate increases, India must meticulously manage the repercussions of foreign outflows on its currency and bond markets. Policymakers must remain vigilant and balance the advantages of foreign capital inflows with the inherent volatility risks. India can transform this financial integration into a long-term asset by implementing appropriate strategies, such as fortifying foreign exchange reserves, ensuring robust liquidity, and sustaining an active domestic investor base.  Ultimately, the FAR route represents a calculated risk with the potential to effect transformative changes in India’s financial landscape. With prudent risk management and a clear emphasis on stability, India can capitalize on its bond market integration to stimulate economic growth while safeguarding the integrity of its financial system. This journey through the international financial markets necessitates that India adeptly balances the welcoming of foreign capital with the imperative of protecting domestic stability, thereby forging a path that could redefine India’s role in the global economy.

(V Shunmugam is Partner, MCQube; Mohammed Reyhan and Ganesh Prabu are Emerging Scholars in Finance at National Institute of Securities Markets.)

Views are personal, and do not represent the stand of this publication.