The Global Outlook on India
India's resilience in the face of global challenges is evident in the World Bank's latest India Development Update (IDU). Despite a tough global environment, India achieved a remarkable 7.2% growth rate in FY22/23, surpassing most G20 nations and nearly doubling the average for emerging market economies.
The inclusion of certain Indian sovereign bonds in key emerging-market bond indexes managed by JP Morgan is witness to India’s appetite for growth and growing appeal to international investors as the country’s economic growth outstrips peers.
What Transpired in September 2023
JP Morgan Chase & Co. announced that it will include Indian government bonds in its emerging markets index. This places India on the list of countries like China, Indonesia, Malaysia, etc.
Indian government securities will be added starting June 2024. According to Bloomberg, this inclusion can result in $25 billion in inflows by March 2025. To understand its wide effect, we need to understand bonds, especially sovereign bonds, foreign investment, and how this will shift India’s future investment paradigm
A bond is a fixed-income investment where an investor loans money to an entity (like a corporation or government) for a set period at a fixed interest rate. The issuer agrees to repay the initial investment plus periodic interest payments over the bond's life. Bonds are lower risk compared to stocks, appealing to conservative investors.
Sovereign bonds, or government bonds, are issued by national governments and are among the safest investments due to being backed by a nation's full faith and credit. They help governments fund projects and manage fiscal policy, with generally low default risk, particularly for stable economies with strong credit ratings.
But why one of the largest investment banks in the world decided to include India’s sovereign bond in its Global Market Index - Emerging Market (GMI-EM) portfolio….. Because it is too big to ignore.
Too Big to Ignore
India’s government bond market stands at a whopping $1.1 trillion which is almost 18% of the total emerging market (EM) government bond market which makes it the second largest after China.
India is the only country that is investment grade but has not been included in any of the major bond indices. Above all, India offers the best economic growth with a sizeable growth of 7-8%.
So, it is no surprise that JP Morgan Chase & Co. decided to include India in its GBI-EM portfolio.
Potential Effects of Inclusion in GBI-EM
With the total amount of Gsecs (Government Securities or Government Bonds) under a fully accessible route in which non-resident investors can freely invest without quota restrictions standing at $289 billion, the Indian bond market will stand as the second largest bond market among emerging bond markets. According to the HSBC and Bloomberg reports, this will result in potential inflows of $25-30 billion in the next five years.
These potential inflows will be beneficial for India as they will help in narrowing the current deficit of India. Also, the inclusion can result in foreign investors holding 12-15% of GSecs leading to diversification of investors and not completely dependent on domestic investors. Hence resulting in resiliency to an extent from domestic investors’ sentiments.
Balance of Payments
The balance of payments (BoP) is a comprehensive record of all economic transactions between a country and the rest of the world over a specific period. It includes both the payments made by a country to other nations (for imports of goods and services, financial capital, etc.) and the payments received by the country from other nations (for exports of goods and services, financial capital, etc.).
These inflows could help contain the BoP deficit and keep domestic liquidity from tightening too much in the short run. During the Pandemic, to support the nation’s economy, the RBI had to shell more from its reserves. This inclusion will help India in these tightening situations.
More for Banks to Lend
With a widening base of investors for GSecs, the statutory liquidity ratio will go down. So banks in India have to spend less to buy GSecs. This will leave banks with a surplus that they can lend to borrowers and earn interest income resulting in increased profit.
*Statutory Liquidity Ratio (SLR) is a regulatory requirement set by the central bank (in most cases, the Reserve Bank of India in India) that mandates a certain percentage of a commercial bank's total deposits to be invested in specified government securities and other liquid assets.
Now we have seen much from India’s perspective but what about the world? What will the world gain from including Indian sovereign bonds in the GBI EM portfolio?
Diversification Benefits for the World
Markets such as China and India are good sources of diversification for global bond investors as domestic considerations drive these markets leading to resiliency and stability in rates.
It was evident during the 2008 financial crisis when the West was suffering a lot, India faced less heat of the crisis.
India has a low correlation or the least beta sensitivity to co-movements in global rates. Such beta characteristics improve the risk profile of the overall bond portfolio and offer investors an opportunity to enhance their returns.
Let’s have a look at Efficient Frontier (EM). The benefit of adding the Indian market to an efficient frontier lowers the risk and increases the return.
*The efficient frontier is a fundamental concept in modern portfolio theory (MPT) and investment management. It represents a set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest level of risk for a given level of expected return
Such correlation characteristics and diversification benefits are partly the reason that many GBI EM tracking funds are already set to invest in Indian bonds
Why Not All?
Only JP Morgan Chase & Co. has included Indian GSecs bonds whereas other major GBI EM Index funds have not included Indian GSecs till now. Let's look deeper into operational challenges that are preventing these funds from including India GSecs:
- Pre-funding for Placing Margin: The need for pre-funding margin requirements presents an operational challenge for funds looking to include Indian GSecs in their portfolios
- Reporting Requirement for Bond Settlement: Meeting the specific reporting requirements for bond settlement adds complexity and serves as a hurdle for funds considering investment in Indian GSecs
- Taxation Issue: Navigating through taxation complexities associated with Indian GSecs poses a significant operational challenge for these funds
- Repatriation of INR Proceeds from Bond Sales: Ensuring smooth repatriation of INR proceeds from bond sales proves to be another operational challenge that funds need to address when considering investment in Indian GSecs
Takeaways from China’s Experience
China’s commitment to opening up its financial market was instrumental in facilitating the inclusion of its bonds into major indices. China government bonds are now included in all three major fixed income indices which are the Bloomberg Global Aggregate Index, JP Morgan GBI-EM, and the FTSE Russel World Government Bond Index.
China policymakers invested significant effort from 2017 to 2021 to increase the index inclusion eligibility of their bond market.
Drawing a parallel from China, India needs to take steps to include its bonds in other funds. A few of the steps that can be taken are:
- Increase bond settlement cycle for foreign investors from T+1
- Exempt foreign investors' corporate income tax and value-added tax on their interest gain
- Remove quota restriction from investment by foreign investors
Investment in India: A Promising Horizon
The inclusion of the Indian GSecs into JP Morgan GBI-EM has set up a precedent for other funds. Now Bloomberg is looking to include Indian sovereign bonds in its fixed-income indices funds. HSBC has also said that it will consider the inclusion of the Indian GSecs by the end of the year 2024.
India looks like the bright spot for investment. The inclusion of Indian sovereign bonds in the world's major indices will have several positive benefits for India, including:
- Increased capital inflows: When Indian bonds are included in global indices, they become more accessible to foreign investors. This can lead to increased capital inflows into India, which can help to finance economic growth and development
- Lower borrowing costs: Increased demand for Indian bonds can lead to lower borrowing costs for the Indian government. This can save the government money on interest payments and make it easier to finance its deficit
- Increased market liquidity: Inclusion in global indices can also increase the liquidity of the Indian bond market. This can make it easier for investors to buy and sell Indian bonds, which can help to improve the overall efficiency of the market
- Improved investor sentiment: Inclusion in global indices is seen as a sign of confidence in the Indian economy. This can help to improve investor sentiment and attract more foreign investment to India
- Enhanced global profile: Inclusion in global indices can also help to raise India's profile in the global financial markets. This can make it easier for Indian companies to borrow money and raise capital from abroad