India's inclusion in the global bond indices could be a gamechanger

It would benefit financials, including banks, particularly the large private banks and non-banks stocks, via lower borrowing costs and higher credit growth

India's aspiration to be a part of the global bond indices could materialise as early as 2022. It could result in inflows in the bond market to the tune of $170 billion in the base case scenario in the next decade and $250 billion in a bullish scenario, which would have broader implications for the economy, foreign exchange and equity markets.

On Wednesday, a Morgan Stanley report predicted that India would be included in global bond indices in early 2022, with Euroclear to announce that India is becoming Euroclearable by the end-2021.

"We expect the index inclusion announcement to happen in 4Q21 and the actual inclusion to happen as early as 1Q22," the Morgan Stanley report said.

"This would attract $40 billion of index inflows in the next two years, followed by annual $18.5 billion inflows driven by active managers' allocation to India," it said.

Upasana Chachra, an economist with Morgan Stanley, wrote that India has a mixed attitude towards foreign bond flows – as the large inflows and outflows would impact the exchange rate. But a major shift to welcome foreign bond flows occurred in 2020 when the government established a programme that allows foreign investors to buy unlimited amounts of government bonds via its Fully Accessible Route (FAR).

This was an effort to push for government bonds to join global bond indices. "This marks a major shift to welcome and attract foreign bond inflows," Chachra said.

There are two reasons why India has been making such a policy shift now. One is the improvement of the macroeconomic fundamentals. First, there is price stability with the monetary policy committee of the Reserve Bank of India (RBI) adopting a flexible inflation targeting regime since 2016, which resulted in inflation staying around the target mark, except for the Covid-19 pandemic year (2020-21).

Second, in the external sector, the current account deficit has remained below 2 per cent of the GDP since 2014. Lastly, there is financial stability, with gross non-performing assets of banks falling to 7.5 per cent - the lowest level in nine years.

Another reason for such a policy shift is the government's willingness to push for capital expenditure driven growth. "The push for capex-driven growth alongside an improvement in macro stability has set the stage for a calibrated opening up of India's government debt market," the report said.

The report observed that the bond inflows would drive India's balance of payments to be in a surplus structurally, improving external stability, lowering the long-term cost of capital, and supporting capex-driven growth.

Impact of bond flows

The declining trend of foreign ownership of Indian bonds will be reversed with the inclusion, with inflows accelerating from 2022, which could lead to foreign ownership of Indian bonds up to 9 per cent by 2031, in a base case scenario, as compared to 1.9 per cent now.

The report expects the government bond curve to flatten by 50bp and the 10-year government bond to trade at 5.85 per cent in 2022.

(1 percentage point = 100 bps)

Economy

On the economic impact, the report said the opening up indicates policymakers' desire to push growth rates higher through investment. "It will push India's balance of payments into a structural surplus zone, indirectly create an environment for a lower cost of capital and ultimately be positive for growth."

The report expects the central government deficit to reduce to 2.5 per cent of GDP and consolidated deficit to reach 5 per cent of GDP by FY2029 from 14.4 per cent in FY2021.

The current account deficit to average at 1.6 per cent of GDP and capital account surplus to be 3.3 per cent in the next ten years. "With inflation near the 4%Y mark and real GDP growth expected to average at 6.5%Y in the next ten years, we estimate the long-term policy rate to be close to 5.5%, thus ensuring real rates remain positive, averaging 1.5%," it said.

Exchange rate

A structural surplus in the balance of payments and improving productivity could drive the rupee to appreciate 2%/year in Real Effective Exchange Rate (REER) terms. "Assuming India's long-term inflation would be 4%Y, this would imply a 2% depreciation of INR in nominal terms. Considering IGBs' [Indian government bond] yield of around 6%, it could offer 4% USD return over the medium term, quite attractive to foreign investors."

Sovereign credit

Foreign inflows would lead to lowering of borrowing costs, which helps debt sustainability. "It is important for India to keep an investment-grade rating. Local market inclusion could reduce the likelihood of eurobonds. We expect 30-40bp of spread tightening," the report said.

Stocks

Equity market returns could be higher due to bond inflows' positive impact on growth and interest rates and accentuate the case for India's return correlations to decline.

It would also benefit financials, including banks, particularly the large private banks and non-banks stocks, via lower borrowing costs and higher credit growth.

(The writer is a journalist)

Disclaimer: The views expressed above are the author's own. They do not necessarily reflect the views of DH.