Context:   

• In late 2023 and early 2024, JP Morgan and Bloomberg Index Services took steps to include Indian LCGBs into their global indices.
• This move increased the attention on efforts for internationalisation of Rupee along with the potential benefits and downsides of this move.

Definition: 

• Government Bonds issued by the Governments in the local currency to raise funds for its activities are called Local Currency Government Bonds(LCGBs).
• Ensuring the availability of these bonds for foreign investors provides benefits like internationalisation of the local currency, availability of cheap funds over longer terms.
• India took active steps in this direction from 2019, starting with the Fully Accessible Route(FAR) method. 
  • FAR shall enable non-residents to invest in specified Government of India dated securities. The eligible investors can invest in specified Government securities without any investment ceilings.  

Benefits from this move:

• Lower borrowing costs: The cost of public borrowing would decline as the influx of foreign funds into LCGBs lowers domestic interest rates.
• Long term loans: Opening local bond markets would facilitate the financing of current account and fiscal deficits by engaging institutional investors with long-term investment horizons.
• Reduced dependence on domestic institutions: It is also expected that these funds would relieve the balance sheets of local financial institutions holding LCGBs, thereby increasing lending for private investments.
• Increased investment: Foreign investors could boost private investment and economic growth.
• Reduced “original sin” problem: Issuing bonds in local currency could lessen vulnerability to exchange rate fluctuations.
  • Original Sin problem in economics means the inability of the emerging economies to borrow internationally in their own currencies.

Risks due to this move:

• Loss of monetary autonomy: The internationalisation of bond markets in emerging economies also entails a significant loss of autonomy in controlling long-term rates and exposes them to greater interest rate risks. 
  • Domestic bond markets can get crippled due to adverse spillovers as seen after the Lehman collapse in September 2008. 
• Currency instability: With the move to floating and increased exchange rate volatility, local currency bond inflows to emerging economies have become increasingly volatile because of the exchange rate risk borne by investors. 
  • There are significant variations over time in the share of foreigners in local bond markets and several instances of sudden stops and exits.
  • This has led to volatility of local currencies in countries like Malaysia(2014-2015) and Turkiye(2018).
• Drain on Forex Reserves: In times of market distress, external debt in local currency plays a greater role in the drain of reserves and currency declines than forex debt because of investors’ exchange rate risk. 
• Offshore Currency Market: Permitting banking services in the rupee INR outside the country is essential in the move to ease the availability of LCGBs to foreign investors. This move could lead to the development of an offshore Rupee market. 
  • Such a market could lead to speculations and increased instability during a crisis situation. This problem was faced by Malaysia and Turkiye in the last decade.

The risks of internationalising bond markets are often underestimated and could lead to increased instability. Experience suggests a more cautious approach based on strong financial systems and economic performance before full integration.