Safety bond

The US Federal Reserve has taken a definitive step towards normalising its easy monetary policy and this can have ramifications for financial markets across the globe. Turbulence can be expected next year as the Fed funds rate begins rising and regulators need to do all they can to insulate markets from such volatility. Fed Chairman Jerome Powell stated that progress has been made towards its twin goals of maximum employment and price stability and if conditions continue to improve, monthly asset purchases of treasury securities amounting to $120 billion will be reduced gradually in the coming months; asset purchases are to end by the middle of 2022. Equity markets appear pleased at the assurance that Fed funds rate will remain close to zero over the short term and that the Fed will not begin shrinking its balance sheet as of now. This implies that global liquidity that is fuelling asset price inflation globally will not be impacted in the coming year.

Bond markets have however turned circumspect with sovereign bond yields hardening in both the US and India. Besides higher inflation projected for 2021 and 2022, the Fed’s resolve to not reduce the outstanding government paper for now has not gone down well as it signals elevated supply in the coming months. Of greater significance is the projection of Fed funds rate by Federal Reserve Board members and Presidents, which indicates one 25 basis points rate hike by the end of 2022 and four more rate hikes in 2023. Interest rate hikes by the Fed can be preceded by periods of volatility in emerging markets as funds are pulled away from riskier assets and moved to dollar denominated securities. Indian sovereign bonds are particularly vulnerable in such periods which makes it necessary to attract long-term investors who can support prices.

In this context, the progress made towards including Indian sovereign bonds in global bond indices is welcome. The introduction of Fully Accessible Route (FAR) for FPIs investing in G-secs in 2020 was the first major step towards this move. Reports that listing of Indian G-secs on international trade settlement and clearing house, Euroclear, is in its final stages and could be completed by the end of the year indicate that G-secs could be included in GBI EM and GBI Aggregate indices by early 2022. Not only will this inclusion result in annual inflows of $18.5 billion over the next decade, as reported by Morgan Stanley, these flows are likely to be more stable and long-term in nature, when compared to the hot money that is influenced by central bank actions and global liquidity. The Centre should however decide on the taxation of these securities when both the buyer and seller are not Indian citizens and the intermediary is also outside India. It will be good if clarity on this is provided in the next Union Budget. Other minor bottlenecks such as simplifying the registration process for FPIs wishing to invest in G-secs, improving the trade matching system and providing access to hedging tools to FPIs should also be expedited.