India bond-tax moves to spur foreign inflows, boost index bid

India exempted foreign investors from taxes on interest earned from government bonds and widened access to the debt market, a move aimed at attracting overseas capital and strengthening the country's bid for inclusion in global bond indexes.

The tax exemption covers interest income from government securities held by foreign portfolio investors. Previously, such income was subject to a 20% withholding tax. The government also expanded the range of bonds accessible to foreigners, removing limits on certain categories and easing registration requirements. The changes took effect immediately, according to a finance ministry notification.

Foreign investors have long pointed to tax treatment and market access as obstacles to increasing their allocation to Indian debt. India's government bonds offer yields among the highest in Asia, yet foreign ownership of the outstanding stock hovers below 2%. The tax exemption removes a tax-related friction that made Indian bonds less competitive on an after-tax basis compared with other emerging markets.

The broader access includes allowing foreign investors to participate in the full spectrum of government securities, including longer-dated bonds, and eliminating caps on the amount of debt they can hold in certain categories. Previously, foreign investment in some bond types was limited or required prior approval from the central bank.

The policy shift comes as India pushes for inclusion in major bond indexes such as JPMorgan's Government Bond Index-Emerging Markets and Bloomberg's Global Aggregate Index. Index inclusion would trigger automatic buying by passive funds tracking those benchmarks, potentially drawing tens of billions of dollars in inflows over several years.

India's case for inclusion has strengthened in recent years. The government reduced fiscal deficits and liberalized capital markets. It also improved transparency. The tax exemption addresses one of the remaining hurdles flagged by index providers. The Reserve Bank of India has also taken steps to make the market more accessible, including allowing foreign investors to hedge currency risk more freely and simplifying the registration process for offshore investors.

Foreign inflows into Indian bonds have been volatile in recent years, with net purchases swinging between large inflows and outflows depending on global risk appetite and domestic policy signals. The tax exemption is expected to provide a more stable foundation for foreign participation, reducing the tax-related friction that discouraged longer-term investors.

The next milestone for index inclusion is likely to come in the second half of the year, when index providers review their country classifications. India's inclusion would be a multi-year process, with gradual weight increases over several quarters. JPMorgan has already placed India on its watch list for the GBI-EM index.

For the rupee (INR), sustained foreign bond inflows would provide a buffer against external shocks. The currency has been under pressure from a strong dollar and rising oil prices. RBI's recent intervention via swaps highlights the central bank's focus on managing volatility.

The tax exemption alone does not guarantee index inclusion. Index providers also consider market liquidity and settlement infrastructure. Capital controls are another factor. India has eased restrictions, however. Some foreign investors still cite execution risk in the bond market, particularly around settlement and repatriation of funds.

Similar tax exemptions have been used by other emerging markets to attract foreign bond investment. Indonesia, for example, exempted foreign investors from withholding tax on government bonds in 2020, which helped boost foreign holdings. India's move follows a similar playbook.

The exemption effectively increases the after-tax yield for foreign investors, making Indian bonds more attractive relative to peers. With US Treasury yields elevated, the spread over Treasuries is a key consideration for global bond investors. A higher net yield narrows the gap and improves the risk-reward profile.

The government's broader strategy includes reducing the fiscal deficit and deepening the corporate bond market. It has also worked to improve the ease of doing business. The tax exemption is one piece of a larger puzzle aimed at integrating India's financial markets with the global system.