The heavy duty sell-off in Indian bonds by foreign institutional investors (FIIs) has not only hurt the currency but also put India's ability to fund its current account deficit at risk. There are many suggestions by economists to deepen India's bond markets, which would improve the flow of foreign capital. FIIs love Indian equities, which is why they own nearly 22 per cent of the listed universe.
It is this elevated levels of foreign ownership that has prevented a major sell-off in equities so far, believe many experts. Despite slowing growth and weak corporate earnings, foreign investors have not sold equities in a big way. FIIs do not have as much emotion for Indian bonds. FIIs own only 1.6 per cent of government securities or sovereign bonds, primarily because the government has a cap on aggregate foreign investments in Indian gilts. Foreign ownership in Indian bonds is low because of the aggregate $30-billion cap. The positive of such a cap would be that low ownership levels would help prevent a sovereign debt crisis, even if a large sell-off would happen. However, the downside of shallow bond market implies poor foreign inflows into bonds and a shallow bond market. Indian bond markets are shallow also because Indian gilts are not part of any emerging market bond index, a structural issue.
Several economists have argued that if Indian bonds were to be part of any of these indices, then the flows into Indian bonds would increase. One of the reasons why Indian bonds are not included in emerging market bond indices is because of the cap on foreign ownership in bonds. This prevents the inclusion into the emerging market indices. According to Standard Chartered's team of economists, India's index inclusion would ease market concerns over funding the current account deficit. Had India been a part of JP Morgan's Government Bond Emerging Markets Global Diversified index and attracted even $20 billion, it could have weathered balance of payments challenges much better.
India's policy makers believe that increased foreign ownership would lead to higher volatility in Indian bonds. However, research suggests little correlation between the two. A country's bond market volatility has more to do with sovereign and external risks rather than foreign ownership.