Expanded foreign participation in India’s government bond market should free sizable resources to facilitate ambitious development plans.
Published: August 3, 2023
Increased foreign investment in India’s public sector will release large-scale resources and sizably increase the capital available for the country’s economic growth.
Deeper domestic financial markets will facilitate more efficient allocation of investment funds and better pricing of resources, easing implementation of national privatization, innovation and sustainability agendas.
Whether domestic capital markets can keep pace with India’s plans to develop its domestic manufacturing sector, position the country as a major technology producer and improve its infrastructure is questionable. Despite India’s sizable economy and its substantial domestic government bond market, the country is excluded from major global government bond debt indexes, so it fails to generate the sizable portfolio inflows associated with inclusion.
If wider index inclusion increases foreign participation in India’s government bond market to 10% from the current 0.9% (source: Institute of International Finance), we forecast that funds available for corporate debt issuers in India could almost triple relative to nominal GDP by 2030.
Foreign funds that allocate local currency investments based on major global bond index ratings lack incentive to invest in Indian government debt.
JP Morgan’s reference index for global government bonds excluded India in 2022. This was attributed to factors including concerns over the potential inadequacy of domestic bond settlement systems and a perception that investor registration requirements, rules on fund repatriation and India’s capital gains tax regime were not aligned with international standards.
Without foreign participation, India’s public sector, including the central government, has funded projects primarily from domestic markets, crowding out resource provision to the private sector. The private sector has therefore capitalized on equity markets.
In the following analysis, we consider the impact of wider index inclusion and conclude that the availability of funds for the corporate sector could triple by 2030.
Without foreign participation, India’s public sector, including the central government, has funded projects primarily from domestic markets, crowding out resource provision to the private sector. The private sector has therefore capitalized on equity markets.
Higher foreign participation in India’s domestic government debt market would increase demand and meaningfully lower the cost of new government debt issuance. It would also free up resources for the private sector. Successful completion of more large-scale domestic corporate offerings would deepen the domestic capital market, providing additional pricing benchmarks and improving liquidity, attracting even greater foreign involvement.
Market estimates suggest inclusion in major bond indexes could attract an initial inflow of US$20 billion-US$40 billion, increasing to US$180 billion over the next decade.
The liberalization of capital account convertibility is “a process rather than an event,” Reserve Bank of India Governor Shaktikanta Das said in November 2020. The suggestion that restrictions on local investors investing abroad will be eased in stages remains the likely trajectory.
Easing rules for Indian companies to raise debt and equity externally and wider sovereign use of major international markets would broaden India’s funding sources.
Existing laws prohibit direct listing of Indian companies on a foreign stock exchange. Secondary overseas listing is allowed, but there are restrictions on overseas issue size and the amount of paid-up capital. At a sovereign level, India’s external borrowing comes mostly from multilateral and bilateral sources, while state governments are not allowed to borrow abroad directly. Plans to raise up to US$10 billion from overseas public debt markets stalled in 2019. India would be well-received if it chose to borrow in US dollars, as demonstrated by past dollar issuance by Indian borrowers.
Simpler tax structures and greater alignment with international practices would increase the appeal of domestic capital markets.
India applies capital gains tax to profits on government bonds, a major constraint driving its exclusion from global bond indexes. The international norm is to permit payment on sale without withholding.
A simpler regime would also reduce tax-based arbitrage between financial products. In the private market, foreign funds and nonresident investors pay a tax on the difference between capital raised and the fair value of securities sold, the so-called angel tax, according to Union Budget 2023. Investors believe that the levy discourages investments by foreign private equity and venture capitalists in India’s startups while hindering broader portfolio inflows.
India applies capital gains tax to profits on government bonds, a major constraint driving its exclusion from global bond indexes.
As of 2022-end, commercial banks owned 38.0% of state and government debt securities, while insurance companies held a further 25%, Reserve Bank of India data shows. This implies combined aggregate holdings of 60 trillion Indian rupees. India’s central government funding is heavily skewed toward domestic issuance, with just 11% of central government debt externally funded. Investing in government securities is a core business activity for banks, with 27% of assets estimated as held in government securities.
S&P Global Market Intelligence’s Banking Risk Service forecasts credit expansion growth to average 13% annually from 2023 to 2030 due to fast economic growth and banks strengthening following the recent large-scale bad loan write-off. With more nonbank financial companies likely to convert into banks over the period, greater availability of funds for domestic investment will accelerate credit provision, bringing the credit-to-GDP ratio to 60.7% in 2030, from about 50% in 2022.
Credit expansion is likely to be uneven given how the government assigns its lending. Approximately 40% of loans will go to priority sectors such as agriculture under the prime minister’s “money scheme,” Pradhan Mantri Jan Dhan Yojana, and to favor small and medium-sized enterprises. Nonetheless, the total stock of bank loans to Corporate India should more than double by 2030.
A broader issuer and investor base should also increase financial sector competition and the availability of long-term debt (notably benefiting infrastructure projects). It would also lower interest rates for corporate borrowers while increasing resource allocation to sectors that boost productivity and employment. This may bolster overall investment returns in India and support economic growth, attracting further investment in India.
Wider participation in the equities market improves the exit options and valuations for startups, while attracting more funding from abroad.
Wider participation in the equities market improves the exit options and valuations for startups, while attracting more funding from abroad.
Few government disposals have been made through capital markets flotations. Greater availability of investment funds — with reduced crowding out by government — would facilitate a more active privatization calendar. Such momentum could also encourage joint ventures with foreign partners providing incremental resources and technologies, implying a further boost to economic efficiency.
The speed at which India’s capital markets catch up with the country’s ambitious development plans will in part depend on the government’s balancing act between capital controls and financial stability.
These capital controls will be eased only gradually during the period to 2030, while flexibility for Indian financial sector investments abroad will increase. Existing controls on foreign investors are unlikely to be tightened.
There is also scope for regulatory change that widens India’s corporate access to overseas capital markets, something that is likely to be gradual and involve ongoing supervision.
This outlook will be balanced against big ticket items on India’s domestic agenda. The central and state governments have provided almost 80% of funding for the National Infrastructure Pipeline, which was introduced in 2019 with projects in energy, roads, railways and urban development worth US$1.3 trillion. India will require a further US$50 billion-US$100 billion annually to meet its net-zero target by 2070, according to an estimate by a government parliamentary panel on finance.
Contributor:
Annie Sabater
Associate Industry Expert, Central Data,
S&P Global Market Intelligence
annie.sabater@spglobal.com
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