India's Bond Market Crossroads: Can Foreign Inflows Withstand the Storm?

The inclusion of Indian government bonds in the JPMorgan GBI-EM indices—completed in March 2025 after a phased 10-month process—was supposed to mark a new chapter for India's financial markets. Yet, six months later, foreign investors are pulling back.

. This article examines whether the selloff reflects a temporary setback or a deeper erosion of confidence, and what it means for strategic investors.

The Promise and the Reality

When India's bonds were added to the GBI-EM index in June 2024, the expectation was clear: passive and active inflows of $20–40 billion would follow. Goldman Sachs projected $30 billion in passive flows alone, while active investors were seen adding another $10 billion by March 2025. By late 2024, $10.5 billion had already flowed in, fueled by yield differentials—India's 10-year bond yielded ~7% versus the U.S. 10-year's ~4%—and the rupee's relative stability.

But post-March 2025, the narrative shifted. shows the rupee weakening from ₹78/$1 to ₹83/$1 by June 2025—the lowest in over a year. Simultaneously, foreign portfolio investors (FPIs) withdrew $3.7 billion from government bonds between April and June 2025, reversing earlier inflows.

The Culprits: Policy Shifts and Global Pressures

1. RBI's Neutral Stance and Rate Cuts:
   The Reserve Bank of India's (RBI) June 2025 decision to cut rates by 50 basis points to 5.5%—the largest single cut in years—was meant to support growth. However, the accompanying “neutral” policy stance signaled slower easing ahead. This dimmed the allure of capital gains, as bond yields stabilized near 6.6–6.8%, compressing the spread over U.S. Treasuries to below 200 basis points for the first time since inclusion.

2. Rupee Vulnerability:
   The rupee's decline was fueled by rising oil prices ($95/barrel), geopolitical risks (e.g., U.S.-India trade tensions), and the U.S. dollar's strength. For foreign investors, the rupee's depreciation erased gains from yield differentials, turning India into a “double loser” for those unhedged.

3. Global Liquidity and Risk Aversion:
   As the U.S. Treasury yield surged past 4.5% in late 2024 due to fiscal concerns, emerging markets faced a “dash for dollars.” India's $670 billion forex reserves—once a source of comfort—are now seen as insufficient to counter sustained outflows. Meanwhile, FPIs have turned to better-yielding markets like Brazil or Turkey, where spreads remain wider.

The Structural Risks

• Index Dynamics: While India's 10% weight in the GBI-EM is now locked in, its appeal hinges on staying there. If yields compress further or the rupee weakens, passive investors may underweight India in favor of higher-yielding EM peers.
• Operational Frictions: Tax complexities (e.g., capital gains taxes on derivatives) and liquidity gaps in secondary markets persist, deterring active investors.
• External Shocks: The RBI's $652 billion forex reserves (as of June 2024) are a cushion but not a panacea. A sharp global sell-off could force intervention, tightening liquidity and raising borrowing costs.

The Silver Linings

• Upcoming FTSE Inclusion: Starting September 2025, India's bonds will enter FTSE Russell's EMGBI index, potentially adding $10–15 billion in incremental flows over six months. This could stabilize demand.
• Fiscal Discipline: India's fiscal deficit has narrowed to 4% of GDP, easing supply pressures in bond markets.
• Long-Term Growth: India's 6.1% GDP growth forecast (vs. global 3%) and reforms like the Production-Linked Incentive (PLI) scheme keep it a growth outlier.

Investment Implications

For strategic investors, India's bonds remain a “hold” but with caveats:
1. Tactical Allocations: Wait for the rupee to stabilize or U.S. yields to retreat. A dip below ₹80/$1 or a U.S. rate cut could rekindle interest.
2. Hedging: Use currency forwards or options to offset rupee risk.
3. Focus on Duration: Shorter-dated bonds (e.g., 5-year paper) offer better liquidity and lower sensitivity to rate hikes.

Avoid overcommitting until the RBI clarifies its policy path and global yields peak.

Conclusion: A Test of Resolve

India's bond market faces a critical juncture. While the RBI's reforms and FTSE inclusion provide tailwinds, near-term risks—from rupee volatility to global liquidity—are formidable. For now, investors should proceed with caution, treating India as a long-term play rather than a short-term bet. The storm may pass, but the path forward demands patience and hedging.