JP Morgan’s recent decision to incorporate India into its Emerging Market bond index has ignited institutional interest in the world’s leading emerging market government bond. However, full acceptance still has significant barriers to overcome.
India’s representation in JP Morgan’s GBI-EM Global Diversified Index, with a value surpassing 213 billion dollars, is predicted to ascend to 10 percent. This shift might translate into passive inflows ranging from 20 billion to 30 billion dollars from foreign index investors.
Later this month, FTSE Russell is set to deliberate on the potential inclusion of Indian sovereign debt into its FTSE Emerging Markets Government Bond Index (EMGBI).
“If multiple index providers make similar decisions, the positive ripple effect on the Indian government bond market could be further intensified,” remarked Jennifer Taylor, who oversees emerging market debt at State Street Global Advisors, in a conversation with Investment Officer. She envisions diminishing interest rates and a gentle nudge in favor of the Indian rupee.
“Investors stand to benefit from a more varied index, coupled with the appealing risk-return dynamics presented by Indian bonds denominated in the local currency,” Taylor further noted.
Deciphering India’s financial landscape
This year has seen foreign investors channeling in excess of 3.5 billion dollars into Indian debt securities. This resurgence, from the previous year’s net outflow of 2 billion dollars and starkly contrasted by 2020’s massive withdrawal of 13.8 billion dollars by foreign investors, is noteworthy. Yet, for India to truly captivate institutional investors and the associated passive capital, its inclusion in multiple indices is paramount, particularly the FTSE EMGBI and potentially the Bloomberg Global Aggregate Index.
However, for a nation boasting the title of the fastest expanding mature economy — one that’s projected to witness a Gross Domestic Product (GDP) growth of 7 percent in the coming year — this challenge seems considerable. Industry pundits suggest there are logical reasons behind this stance.
Lee Collins, at the helm of index bond strategy at Legal & General Investment Management (LGIM), identifies the primary roadblocks: apprehensions about rupee exchange mechanisms, transaction settlements, and taxation structures. Collins posits that the near-term likelihood of India making its mark in other dominant bond indices, especially the Bloomberg Global Aggregate Index, appears distant. These indices mandate “Euroclear eligibility” for settlements and demand elevated sovereign credit ratings. At present, credit rating agencies like Moody’s, S&P, and Fitch confer upon India the most basic investment-grade credit rating.
Nevertheless, Collins opines that administrative challenges shouldn’t be the sole criterion for sidelining a nation. He observed that investors’ endorsements for newly inducted countries usually start on a note of caution. However, emerging markets, with China as a prime example, have witnessed stable capital inflows during their period of inclusion.
“Several countries that have already made their way into the aforementioned indices grapple with analogous challenges. Yet, bond issuers from India proffer superior returns compared to their counterparts in China and the U.S. In terms of volatility and maximum drawdown, the metrics remain consistent,” Collins elaborated.
The Rupee’s performance
A persistent concern among bond investors centers on the Indian rupee’s historical underperformance against western currencies. Over the past two decades, Indian ten-year government bonds have averaged returns of 7.5 percent annually. However, during the same timeframe, the rupee depreciated by 45 percent against the U.S. dollar, translating to an average annual decline of three percent.
Taylor notes that the mere inclusion in an index isn’t a magic bullet against the headwinds stemming from interest rate differentials, which largely influence currency valuations. “At its best, index inclusion might offer marginal respite for the rupee, stemming from favorable technical dynamics.”
ING’s economic research division posits that while the rupee might momentarily bask in the positive spillover from the inclusion of Indian government bonds in global bond indices next year, its inherent depreciation trend is likely to revert. This sentiment is echoed by Robert Carnell, Chief Research Officer for the Asia Pacific region.
Conversely, Erik Lueth, an emerging markets economist at LGIM, holds a more optimistic view. He contends that the perceived weakness of the rupee is more a reflection of the dollar’s overarching strength. “Given the dollar’s proximity to historic zeniths, it’s more probable that the U.S. currency will cede ground to the rupee in the upcoming decade,” Lueth shared in response to queries from Investment Officer.
“India’s economic foundation is considerably sturdier now. The nation boasts a balanced current account, muted inflation, and positive real interest rates. The potential for investors to reap benefits is significantly more pronounced now than a decade prior,” concluded Lueth.