Bonding with the world: Will more inflows give India’s economy the booster dose?

These inflows come with their own risks and challenges. And there is considerable divergence of views on when the foreign funds may start flowing into the country. But from a macroeconomic perspective, there is unanimity on the fact that a surge in flows is expected to bolster India’s overall fiscal and balance of payments dynamics. Also, higher inflows could help keep the rupee strong, but could have an impact on retail inflation.

What was JP Morgan’s decision?

The inclusion of government bonds will be staggered over a 10-month period, starting June 28, 2024, through March 31, 2025. JP Morgan’s bond index will include eligible bonds from India in its emerging market and derivative bond indices. Global investors allocate funds to various countries depending on their weightage in leading indices. This means that if India can get into more such bond and equity indices, capital inflows will rise significantly.

As per analyst estimates, this inclusion could possibly result in inflows of around $25-30 billion into the government securities market.

“With the exclusion of Russia and troubles in China, the options for global debt investors have narrowed down. Hopefully rating agencies will respect investors’ viewpoints and give up on their moody and poor standards,” said Nilesh Shah, MD, Kotak Mahindra Asset Management Company.

Goldman Sachs believes that foreign funds may start flowing in immediately into the country. “Given that several EM (emerging market) dedicated funds are already set up on India, we think the flows will be front-loaded, beginning immediately, as investors pre-position for inclusion next year,” Goldman Sachs said in a note.

“The timeline was likely dictated by strong demand from the benchmark investors and the ongoing re-weighting exercise. The move carries potential for strong foreign portfolio inflows. The quantum will also be influenced by broader risk-appetite. Flows will be supportive of the fiscal and balance of payments dynamics,” said Radhika Rao, senior economist, DBS group.

More index inclusions on the way?

It’s not JP Morgan alone. Others are reported to be waiting and watching. Another major index provider, FTSE Russell, also has Indian bonds on index watch for inclusion in its emerging market gauge. Incidentally, the FTSE Emerging Markets Government Bond Index-Capped (EMGBI-Capped) oversaw total funds (AUM) of $1477 billion as on end August, making it six times plus larger than JPM GBI-EM GD. “If the inclusion process at JPM GBI-GM materially stabilises, we can see another bigger inclusion by mid-2025,” said an analyst.

“We believe choosing the JPM GBI EM could be a deliberate move on part of the government and the RBI to ensure future developments have a natural progression, evolving and maturing organically to mitigate possible points of friction. Add to this the third index, the Bloomberg Barclays EM bond index, and the funds flow numbers significantly go up,” said Soumya Kanti Ghosh, Group Chief Economic Adviser, State Bank of India.

Post the inclusion into JP Morgan EM Bond Index, India’s chances of inclusion into Bloomberg Global Aggregate Index also rise, IDFC First Bank said in a note. “In case India is included in the Bloomberg Global Aggregate Index, it could result in inflows of $15 billion to $ 20 billion with India’s weight ranging from 0.6 per cent to 0.8 per cent,” it said.

What will be the impact?

Interest rates: Analysts say high inflows could put downward pressure on interest rates. The foreign demand for government bonds will push down their yields, which, in turn, will ease pressure on interest rates in the financial system. This will happen much earlier than the date for inclusion, which is June 2024.

Corporates & markets: Most of the corporate bond yields are benchmarked to the yields on government bonds. “Therefore, yields will decline pan India, across industries. The decline in the cost of capital will translate into higher profits for the corporate sector, which, in turn, will boost stock prices enabling the stock market to scale higher levels,” said V K Vijayakumar, chief investment strategist at Geojit Financial Services.

The growing bond market is expected to scale up further with the widening of investor base and stable flows. “This (JP Morgan) inclusion will deepen the bond market in India,” Shah of Kotak AMC said.

Rupee: On the other hand, higher inflows are likely to keep the rupee strong but put the pressure on retail inflation. However, the RBI has various instruments to keep the rupee stable and maintain the liquidity position at a comfortable level. Strong inflows have the potential to push up retail inflation

What’s the impact on the external front?

The rise in inflows with India’s inclusion in the JP Morgan GBI-EM index and the possibility of inclusion by other global indices means foreign exchange reserves are expected to get a big boost in 2024 and 2025. Positive sentiments around the JP Morgan index inclusion could lead to some inflows in the remainder of FY23. With current account deficit (CAD) expected in the range of 1.5-1.6 per cent of GDP, these flows will help to augment India’s balance of payment (BoP) surplus. However, actual inflows are expected only post June 2024, when the bonds are formally included in the index.

According to a Bank of Baroda report, these inflows will be crucial as India’s CAD in FY25 is expected to reach 2 per cent of GDP, amidst a pickup in global and domestic growth and higher commodity prices. In such a scenario, index-related inflows will help in funding the higher CAD and build up foreign exchange reserves.

“This will require more rigorous monitoring and intervention by the RBI, suggesting that some of the forex reserves accumulated due to index-related inflows will be required to keep the currency range-bound,” it said.

Overall, India’s growth is expected to get a booster dose in FY2023-25. The RBI has projected a growth rate of 6.5 per cent for the current financial year.

What are the concerns?

Heavy flow of foreign debt comes with its own macro-prudential risks. While the risk of retail inflation rising is a possibility, FPI (foreign portfolio investors) flows tend to be volatile and are highly dependent on exogenous factors. “In the case of any adverse external shock, investors tend to move away from riskier markets like India, which can lead to a capital flight. This will leave India’s financial markets prone to heightened volatility. Both bond markets and the domestic currency will be impacted,” the BoB report warned.

The sudden exit of foreign investors can also impact the stock markets, leading to huge losses for investors.

Historically, there have been some instances when capital outflows have resulted in a rapid depreciation in the rupee. In short, inclusion in such indices makes the country susceptible to higher financial sector volatility. This would require robust monitoring and intervention by the RBI and government. As such, RBI will have its task cut out to ensure stability in the financial markets and prevent spillovers from financial markets in the real economy, it said.

What are foreign players up to now?

So far, in the calendar year 2023, foreign portfolio investors (FPI) have invested Rs 28,905 crore in the country’s debt market compared to an outflow of nearly Rs 9,000 crore in the same period of 2022. One of the reasons for these inflows, though minuscule by global standards, was the expectation that the country will be included in the global bond indices. Other factors for the inflows into the debt market included higher interest rates, improvement in growth prospects of the country, lower inflation compared to other economies and stable rupee.

Market experts believe that with clarity on inclusion of Indian bonds into JP Morgan’s emerging markets bond index, inflows into the debt market will be driven more by outlook on inflation, economic growth and interest rate scenario. They also believe that FPI investments into equities may slow down on overvaluation concerns.

FPIs have infused Rs 1.22 lakh crore into Indian equities so far in the calendar year 2023. However, there has been an outflow of Rs 10,164 crore from the equity markets by FPIs in September.

However, Nomura in its report said the risk of further outflows is rising, as sentiment is deteriorating from twin deficits and election concerns. “Our equity strategists think that elevated oil prices may also provide a reason for foreign investors to reduce their equity holdings,” it said.