Foreign inflows into Indian government bonds have turned positive this calendar year (the highest since 2017) with foreign portfolio investors buying a net Rs 127.2 billion ($1.53 billion) of bonds (according to data from the Clearing Corporation of India). Foreign buying is picking up in anticipation of India’s inclusion in JP Morgan’s Government Bond Index-Emerging Markets (GBI-EM) from June 2024.
The move is being keenly watched by market participants as it is expected to bring in inflows of $20 billion-$25 billion in index-eligible government securities between June 2024 and March 2025. Inflows will be staggered, in line with the staggered increase in India’s index weightage to 10 percent. The country’s inclusion in the GBI-EM index follows Russia’s exit from it.
No doubt, the inflows will be beneficial for funding the country’s GDP growth. They will also help the government manage its fiscal and current account deficits, besides funding bank lending to corporates with the pick-up in the capex cycle. But will they move the needle on rates?
The fact is that Indian bonds are no longer as attractive on interest rates to foreign investors as before. That’s because the spread between Indian and US government 10-year bond yields has narrowed to ~300 basis points from ~588bps in 2020. The spread dipped to ~235 bps when 10-year US Treasury yields surged beyond 5 percent in October-November this year. Although benchmark US Treasury yields have softened further following the Federal Reserve’s 13th December announcement of multiple rates cuts in 2024, the spreads are still not attractive enough. The last major inflow of FPI flows in the debt markets was in 2014. At that time, the spread was attractive at 642 bps, along with the Indian 10-year G-sec at 8.75 percent which was at a very appealing level on absolute basis too!
Frankly, the 13-year-long low-rate regime from 2009 to 2021 was an aberration. Now that the genie of near zero rates and easy money has finally been put back into the bottle, it is unlikely to be let out again soon.
Besides, our linkage with US Fed action on rates is tenuous on the downward trendline. Although India tends to raise rates when the Fed increases its benchmark, we do not usually follow suit when it cuts rates. The Reserve Bank of India left the key repo rate unchanged at 6.5 percent for the fifth consecutive time in its Monetary Policy Committee (MPC) meeting on December 8, owing to inflationary concerns. So, the prolonged pause on interest rates is likely to continue in India into the first half of FY2025 at least.
While core inflation has come down steadily – the CMIE’s Core CPI index (CPI excluding food, fuel and light, and fuel used for vehicles) fell to 4.2 percent in November 2023 from 4.5 percent in the previous month – food inflation continues to remain elevated and volatile. Higher food prices pushed up headline inflation to 5.6 percent in November from 4.9 percent in October 2023.
Economic activity continues to be strong with the RBI expecting the economy to expand by 7 percent this FY. Also, the quantum of government borrowings is unlikely to come down in 2025 given the targeted fiscal deficit of 5.9 percent of GDP for 2023-24.
In the past 26 years that I have been tracking the markets, government borrowing has never fallen in any single year. Also, while private sector capex is picking up, the government spending engine will still need to keep firing to fuel growth.
The country’s inclusion in the JP Morgan GBI-EM index is expected to open doors to its inclusion in other indices such as the Bloomberg Global Aggregate Bond Index, which would increase foreign flows further. But nothing is on the cards yet. On the other hand, the risk of volatility and outflows from India will be constrained by the reputational risk to the GBI-EM index in the initial days.
Also, since India has just been included into the index, the reshuffling/reduction in weights will take some time, especially as India is expected to grow at a potentially higher rate than other EM peers and the rest of the world. Thus, reducing Indian bonds in the Index will not be easy. One-time inflows will happen, although incremental flows may be lower assuming the expectation of a recession in the West.
Benchmark interest rates are in neutral territory today, and home loan rates are fairly reasonable too at ~8.5 percent. The average yield for the 10-year G-Sec has also been ~7.20 percent for the last 10 years.
I expect the 10-year G-Sec yield to remain stable and range-bound between 7.20 percent and 7.30 percent in 2024, mainly due to the fact that demand for bonds will be limited to the Pensions and Insurance sector. There is a strong credit offtake in the banking system and therefore banks will not be investing in extra SLR (if not selling the extra stock). Debt flows in mutual funds have also slowed to a trickle in view of taxation changes, and therefore will not be active participants.
In a high-growth economy, liquidity is expected to be tight, so there is no spare money to hold extra G-sec and the cost of funding is also high.
While supply of bonds will continue to weigh on the markets, undoubtedly, some window of softening will open up as it did in 2023, but it is difficult to time the market. In any case, equities will continue to be the preferred asset class for foreign inflows.