India Market Outlook: Time for India bonds?

The spotlight on Indian investments so far this year has been on its booming equity market. As Indian stocks seek to push new highs, risks to the downside have gathered, from growing global macro headwinds to limited policy support from the government. Instead, Indian bonds – which were recently included in a major EM index – could offer defensive positioning and diversification and appear attractive at these levels.
The bright side
Firstly, recent enthusiasm for India stocks has been rightly placed. India is the fastest growing major economy in the world this year and fast becoming a major propeller for global growth. Underlying growth drivers have been boosted by strong domestic demand: GDP growth improved to 7.8% y/y in Q2 from 6.1% in Q11. Private investment and bank credit growth have continued to trudge upwards in Q22 fueled by a strong service sector that’s pushing India’s gross value added higher3.
A strong case could be made for investors to have a bullish long-term view for Indian equities. Domestic demand appears to be broadening and the economy is becoming more diversified. The government’s structural reforms and infrastructure investments are starting to bear fruit – leading the way for corporates to ramp up their capital expenditures. There has even been a pickup in new investment projects announced over the past couple of quarters which means that this capex cycle could churn higher and boost growth in the coming years4.
Last but not least, India is experiencing both financial deepening and broadening. Financial inclusion through the “India stack” of digital financial services underpinned by the public Universal Payments Interface and other technological enhancements is bringing increasing numbers of Indians into the formal financial system. Meanwhile, domestic savings are finding their way not just into bank deposits but also capital markets, especially equities.
The challenges
However, these structural supports may face shorter-term headwinds. Even though domestic household consumption has recently boomed, pushing the economy to firmer ground, it may not be enough to completely offset external challenges that are coming to the fore.
The global macro backdrop appears uncertain - India’s exports in Q2 disappointed due to faltering foreign demand5 and the break-out in oil prices is likely to raise inflation expectations and exacerbate the country’s trade deficit6. More so, gross and net FDI flows have also weakened this year, surprisingly so as MNCs seek to de-risk from Chinese supply chains. These dynamics could pressure growth in the coming quarters. GDP estimates in FY24 ending March 31, 2024 show growth slowing to 6% from the 7.2% in the prior FY7.
While the government has the fiscal and monetary tools to counter growth headwinds, there may be limited space for supportive measures. Policymakers have already instituted a significant multi-year stimulus policy to support infrastructure investment. From a monetary policy point of view, there is little leeway for the Reserve Bank of India (RBI) in the face of a hawkish Federal Reserve.
Instead, the RBI is likely to maintain restrictive monetary measures in order to fend off depreciation pressures on the rupee while also clamping down on high levels of inflation. Even though core inflation is experiencing a disinflationary trend, the spike in food and energy prices has pushed headline inflation above 6%8, with the fear that seepage into core CPI could happen over time. Restrictive monetary policies have started to raise borrowing costs and drain liquidity from the markets and could constrain any further pickup in household demand.
Given these near-term growth hurdles coupled with a narrative that major central banks around the world could hold interest rates higher for longer, I think investors could benefit from a more defensive positioning over the coming quarters.
The impact of index inclusion
Right on queue, a positive development for Indian bonds has just occurred. Finally, after a 10-year wait, India government bonds will be included in JP Morgan’s emerging market sovereign bond index9.
This index has around USD 213bn in AUM and is popular among global investors. The cap for India’s weighting in the index is expected to be 10%, which means around USD 21 - 40bn of inflows to gradually start in June 2024 at a 1% monthly clip until March 2025. The top end would be more likely if other index producers such as the Bloomberg Barclays EM indexes and a few others also add India. Further inflows could also come from active investors.
While I don’t think that the inclusion is likely to have any meaningful impact on local yields in the near-term, this is a notable development because the inclusion is likely to usher in new liquidity to the bond market. Foreign ownership of Indian government bonds has historically been very low, when compared to other emerging markets10 though that could start to change with the inclusion. The Indian government bond market has largely been flying under the radar and is vast enough to accommodate greater flows.
The India 10-year government bond is currently yielding 7.18%, a touch above the ICE BofAML sovereign local currency debt index yield and meaningfully above the US 10y yield11. Still, greater foreign fund flows into the Indian government bond market could also bring risks. Indian policymakers have been somewhat reluctant to open local fixed income markets up due to possible market volatility that could constrain policy actions.
Because India’s economy has twin deficits, this makes the India market more susceptible to volatile capital flows when these deficits widen. Still, index-eligible bonds represent only about 5% of the total US$1.25tn equivalent of Indian government bonds, so the risk posed by foreign capital flight seems moderate and manageable. Another risk to bond yield is the upcoming election next year, though all indicators point to a continuation of the Modi government.
Still, the inclusion is likely to boost higher participation from international investors which should further push policymakers to improve the country’s financial market infrastructure and governance. This inclusion could very well be the start of more efforts by the government to open up the country’s local bond market to foreign investors - though opening measures are likely to be gradual, given the government’s imperative to maintain financial stability.
In the near-term, with a very uncertain global macro backdrop that could keep interest rates higher for longer, I think it makes sense to start positioning a global portfolio to be overweight fixed income relative to equities, although this positioning is balanced by a regional bias towards EM.
Within EM, I think Indian government bond appear attractive at current yields. The moderate, gradual further opening up of the bond market suggests that the Indian government should remain somewhat insulated from further global fixed income volatility should US Fed or other major central banks need to tighten further.
Even though the RBI is likely to maintain a restrictive monetary policy path, I don’t expect any more rate hikes since the fiscal demand-supply dynamics of the country are normalizing and remain favorable. The current low levels of foreign involvement in the Indian bond market coupled with the passive inflows next year due to the index inclusion could mean that the time has come for in India bonds.

With contributions from Arnab Das, Vikas Garg and Yifei Ding
Reference:
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1
Bloomberg, India GDP Q2 and Q1 2023.
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2
Macrobond, India bank credit growth Q2 2023.
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3
Macrobond, India contribution to gross value added (GVA) at Basic Prices, Q2 2023.
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4
CMIE, India new investment projects announced.
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5
Bloomberg, India exports in Q2 2023.
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6
Macrobond, India oil dcit (imports – exports) and current account balance, rolling 12 months.
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7
Bloomberg, India Fiscal Year 2024.
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8
Macrobond, India core CPI, CPI – food and beverages sub-index, August 2023.
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9
Financial Times, “JPMorgan adds India to pivotal bond index”, September 22, 2023.
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10
Macrobond, Foreign ownership of government debt.
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11
Macrobond, India 10y yield, ICE BofAML sovereign local currency debt index yield, US 10y yield.