Hello!! We are officially 50% of the way through 2024. With the midpoint of the year just around the corner, its a time when many of us are finishing off planning for the second half of the year.

 

Indian cricket team made us all proud - what a weekend when we Indians lifted the World Cup trophy after 2011.   

 

I will give you one more reason to celebrate - India's inclusion in the JP Morgan Emerging Bond Index, which was announced in September 2023 when we came out with a piece (Alpha Research).

 

Historically, most Indian government bonds have been owned by domestic investors, with just ~2% owned by foreigners. The Indian bond market has had restricted foreign ownership for the past 20 years, in contrast to the country's equities market, which was completely opened to international investors in 1993.

 

But when India's G-Sec is added to the Global Emerging Markets (EM) Bond Index in June 2024 and the Emerging Markets Local Currency Government indices in January 2025—an announcement by Bloomberg in March 2024—this dynamic is expected to shift drastically.

 

A few other global indexes are expected to follow suit. Governments strive to include their bonds in indexes to increase liquidity, reduce borrowing costs, and provide worldwide visibility and easier access to money. By validating economic policy, inclusion increases investor confidence and stabilizes currency values. Bonds become more liquid as more investors participate, which lowers transaction costs and volatility.

 

This textbook example of a market reaction to long-anticipated news reflects the market's ability to absorb and price information over time. This is reminiscent of the Efficient Market Hypothesis (EMH), one of the basic concepts in finance theory. It states that when new information comes into the market, it is immediately reflected in stock prices, and thus, neither technical nor fundamental analysis can generate excess returns. In its weakest form, which is also the most typical, the market absorbs all available information and reflects it in the prices.

 

This context necessitates understanding the psyche of global investors. For them, investing in emerging markets offers unique advantages, including diversification and uncorrelated returns with traditional asset classes. Because it provides portfolio diversification and a risk mitigation tactic, these markets draw in investors who want to spread their risk.

 

Its an attractive opportunity for people looking to expand their investing horizons. However, compared to their developed market counterparts, investing in bonds from emerging markets entails greater political and economic risk, which results in lower credit ratings. Because of this risk-reward ratio, these bonds usually have higher yields to attract investors. Popular emerging market bond indexes are frequently consulted by investors who are eager to invest in this asset class as they want to diversify their holdings and take advantage of future growth prospects by adding these bonds to their portfolios.

 

This understanding helps us to appreciate the role the global bond index plays. It serves as a benchmark to gauge the total return performance of government and corporate bonds issued by emerging market countries that meet specific liquidity and structural criteria.

 

Moreover, different kinds of investors – active and passive - base their decisions on these different indices, and its vital to understand the consequences - A passive investor base brings stable money, ignoring short-term volatility. To stay close to the standard, investors in major benchmarks usually have some exposure to each country.  This stands in contrast to active money managers, who can reallocate funds from one country to another as they change their short-term views. Furthermore, understanding the index's rebalancing schedule is also essential for investors.

 

Current Specifics

 

Starting on June 28, 2024, the inclusion will take place at a rate of roughly 1% weight every month for 10 months, ending on March 31, 2025. The maximum weight of 10% in the GBI-EM Global Diversified Index, 8.7% in the GBI-EM Global Index, and 14.59% in the GBI-EM Global Diversified IG 15% Cap Index is anticipated for the index weighting of India bonds. This would bring in a new audience of emerging market credit-focused investors.

 

Why now?

 

Although India has the second-largest emerging market bond market, global bond indexes did not include it until 2023. Several reasons explain this exclusion. J.P. Morgan's 2020 index review attributes India's exclusion from global bond indices to taxation rules, capital control issues, custody and settlement issues, and operational constraints.

 

These obstacles impede India's global benchmark integration. In recent years, lower current account deficit, higher FX reserves, flexible inflation targeting, and a stable Government at the Centre have all set the stage for inclusion. India also eases paperwork for foreign bond investors.

 

While international investors are often drawn to India due to its demographic potential, the nation's stable economic indicators, encompassing factors like inflation, fiscal deficit, and growth, further elevate its attractiveness on the global stage. Indian bonds' participation in global bond indices shows foreign investors' growing interest. In addition, India's geopolitical relevance, the search for alternatives in the context of China's economic troubles, and Russia's exclusion from these indices owing to the Ukraine crisis have contributed to this trend.

 

Which bonds will be included?

 

 

 

 

All Indian government bonds classified as Fully Accessible Routes (FAR) that mature after December 31, 2026, would be eligible. 27 bonds with an average term of roughly 7 years and a yield to maturity of approximately 7.09% are included in the index. The 7.18% benchmark 10-year government bond, which matures in August 2033, will be the most heavily weighted at 0.59%. The 40-year bond maturing in June 2053 and the 13-year in July 2037 will weigh above 0.5%.

 

How large are expected index-driven inflows?

 

It is expected that the inclusion of Indian bonds in the JPMorgan index will bring $20–25 billion in foreign capital into domestic debt. The rise in foreign investment is also attributed to non-resident interests, which are expected to double from 2.5% to 4.4% in the coming years. The actual flows may be higher, contingent on market dynamics and active flows.

 

Unlike other developing nations, India's financial assets have also survived pandemics and global economic turbulence. Funds and portfolios that track global bond indices must adjust their holdings to reflect the new inclusion, leading to significant benchmark-driven flows and potential short-term price movements.

 

 

Potential reallocation from other countries

 

The inclusion of India in the bond indices will affect other economies. The index weight for the Europe, Middle East, and Africa (EMEA) region is predicted to suffer the greatest regional impact; it will decline from approximately 32% at the beginning of this month to 26.2% by March, when India's inclusion is completed.

 

Additionally, estimates indicate that the addition of India may take $11 billion away from the local markets of South Africa ($4.7 billion), Poland ($3.3 billion), and Thailand ($3.2 billion). Additionally, a Reuters report states that it will take $2.9 billion and $2.5 billion from Chile and the Czech Republic, respectively. With India's addition, Asia's weight is estimated to increase to 47.6% in the index. In sum, these changes would modify the index characteristics and the changes due to India's rating and volatility.

 

What will it bring to the Indian market?

 

India's inclusion validates its economic reforms and macroeconomic stability, communicating to international investors that it is a legitimate and attractive investment destination with good long-term prospects. It further disciplines Indian policymakers and issuers in the market. The country's fiscal and monetary policies become more crucial as it seeks index status and investment.

• As of June 24, 2024, the yield on the benchmark 10-year government bond (6.971%) had already dropped below 7%.  The fall in the yields cannot be solely attributed to the increased demand for Indian government securities. Other factors are expected interest rate cuts, cooling inflation and the RBI's ongoing assistance through its GSAP (Government Securities Acquisition Programme). In the past, India has witnessed one of the steepest bond curves, which can be flattened in the medium term. A fall in yields also lowers borrowing costs for the government.

 

 

• Financing India's current account and fiscal deficits as it offers an avenue to raise funds from international investors and alleviate pressure on the domestic market. Diversified sources of government borrowing and positive sentiments around the index inclusion resulting in increasing inflows combined with a projected current account deficit will be crucial in bolstering India's balance of payments.

• It paves the way for greater international integration of the Indian economy. Increased foreign investment reduces crowding out risks, providing more leeway for the government to extend credit to the private sector and further stimulate capital market development.

• The inclusion promises a substantial transformation for Indian businesses, opening the door for international finance and giving Indian companies a chance to succeed in a changing global financial market. Indian firms can get cheaper overseas finance with this inclusion, and decreasing borrowing costs benefits Indian enterprises immediately. Lower corporate interest costs mean more money for expansion, research, and innovation, fueling businesses' growth engines, technological improvements, and market competitiveness. This can boost company investments, boosting economic activity and employment.

• International investment in Indian Government Bonds may affect India's domestic corporate bond market, which foreign investors frequently neglect. As foreign investors become more familiar with Indian government bonds, their willingness to take on risk in India may increase, which could be leveraged by NBFCs and HFCs with strong parent company backing and solid financial positions to gain access to more funding options and lower borrowing costs.
• The Indian rupee may appreciate the increase in demand for inclusion. This may cut the cost of imported items but may hurt the country's export competitiveness by making its goods more expensive for overseas purchasers. Exchange rates can affect trade balances, causing deficits. Repayment costs rise with a higher local currency, making foreign currency debt servicing difficult.
• Increased volatility, at least in the short term, is expected, as observed in the case of China and Saudi Arabia when the inclusion took place in 2019. While the future holds much promise, it also demands more proactive intervention by the government, central bank, and, ultimately, investors. This would make it imperative to expand the toolkit to manage interest rate risks, calling for wider liberalization of the derivatives market.
• More global investors lead to higher trading volumes and better liquidity in financial markets, making it easier for investors to enter and exit positions and reduce transaction costs.
• Market Depth: Diverse global investors contribute to deeper and more resilient financial markets, which can better absorb shocks and volatility.
• New Financial Products: Increased attention can drive the development of new financial products, such as derivatives, exchange-traded funds (ETFs), and green bonds, catering to the needs of sophisticated global investors.
• Improved Financial Infrastructure: Developing economies often invest in improving their financial infrastructure, including trading platforms, regulatory frameworks, and transparency standards, to attract and retain global investors.

 

 Final thoughts…

 

My dear readers, note that striking a balance between attracting foreign capital and ensuring competitive conditions for domestic investors becomes a crucial consideration for policymakers, requiring careful management, rigorous monitoring and intervention by the RBI. 

 

What's most important is to assess how much these flows will sustain in the long term.  Long-term gains are significant because India will become a global fixed-income player. In the long run, the collateral and second-round benefits are substantial. I hope this improves the fixed-income ecosystem, which has struggled except for government bonds, which have dominated the market. The main factors are market valuation and returns, ease of access for investors, currency convertibility and outlook, and market liquidity.  

 

Despite this positive outlook, increased global market volatility, policy autonomy loss, and currency issues may affect India's growth trajectory. Market distortions and volatile external financing are other issues. International investors entering the Indian market might cause volatility due to global sentiment and economic situations.

 

Despite the availability of opportunities, governments must manage these risks when accessing foreign finance and visibility to maintain financial stability and economic growth. It is vital to anticipate and manage their possible implications. Central banks may act to stabilize exchange rates, and investor sentiment, market speculation, and policy responses can increase currency volatility. In the face of these challenges, governments must preserve economic stability through transparent communication and targeted measures.

 

Meticulous planning would allow the Indian financial industry to maximize its prospects, and it aligns with India's goal of becoming a $5 trillion economy by 2030, offering a considerable boost toward achieving this ambitious target. It's crucial to acknowledge that while this reasoning provides a plausible connection, economic dynamics are multifaceted, and other contributing factors may influence the market's growth.

 

With a few learnings, and a heart swelling with pride, Signing off as World champions!!

 

Best Regards
 
Dr. Tarunika Jain Agrawal Ph.D. 

Alpha Research

 

Disclaimer

The above views are our expectations of the economy, market and investments. The views may or may not play out accordingly. You are requested to do your own due diligence before making any investment.