India bond Inclusion in JP Morgan index may trigger $20-40 billion flow. Is it enough?

Namrata Mittal, chief economist, SBI Mutual Fund, agrees that this is sentimentally a positive move in near-term and structurally positive over the medium term by helping lower the risk premia of IGB. “It creates an additional source to fund the current account deficit and fiscal over the next one or two years. But once this initial adjustment is done, it will lend relatively higher volatility to the Indian bond market and Indian foreign capital too,” she adds. Mittal explains that in the near term, it could help cap potential adverse movements in the rupee or Indian bonds due to higher crude or higher global bonds yields or stronger dollar respectively.

Goldman Sachs estimates that India’s inclusion could prompt passive inflows of around $30 billion, comprising emerging markets local dedicated funds as well as blended funds over the scale-in period as a one-off stock adjustment.

However, given India’s attractiveness from a yield and (low) volume perspective, Goldman Sachs thinks it could attract at least another $10 billion of active flows (ie, overweight positioning, off-index flows by cross-over funds as well as total return positions). “In total, we think India’s fixed income markets could see inflows upwards of $40 billion over the next one-and-a-half years [where the phase-in period will be completed by March 2025]. Given that several EM 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,” it adds.

According to Madan Sabnavis, chief economist, Bank of Baroda, the move may fetch forex worth $30 billion build up over time and positive for India’s balance of payment (BOP) with foreign reserves increasing. “This will however depend on how India’s current account deficit and other capital flows behave. The rupee will tend to appreciate, but we can assume Reserve Bank of India will intervene to keep it range-bound,” he adds.

Foreign institutional investors (FIIs) that had been keeping away from Indian bonds made a turn-around in 2023, after three consecutive years of outflow in the asset class. Data showed, FIIs bought around $3.59 billion worth debt instruments in 2023 after a net outflow of $2 billion in the previous year. In 2020, FIIs were net sellers of Indian debt instruments, worth $13.76 billion.

Since November 2022, IGBs, under the fully accessible route (FAR) category, have seen sustained inflows on a monthly basis and reached nearly $4.5 billion year-to-date through mid-September, offsetting outflows under the regular and long-term categories. Accordingly, total foreign holdings of IGBs under the FAR category have increased from 2.4 percent to 2.8 percent of the total FAR outstanding.

Also read: Oil or bond yields—what spooked Indian stock markets

“Therefore, we think foreign demand for IGBs, mainly under the FAR category, is poised to remain firm, especially if index inclusion optimism spurs front-loading of foreign inflows in the coming quarters, and in a more subdued manner through 2024-2025,” Rahul Bajoria, managing director, head of EM Asia (ex-China), economics, Barclays, says.

Bajoria expects IGBs’ inclusion in the GBI-EM Index to directly bring in $20-25 billion of passive and active index-tracking inflows over the 10-month phase-in period. He adds that the announcement of bond index inclusion should temper fears of a weakening balance of payments position due to high oil prices.

“We see modest upside risks to our current account deficit forecast of $40 billion, but the financing of the deficit is unlikely to be a major concern. We estimate the balance of payments to remain on track to being in a small surplus,” Bajoria explains.

Nomura analysts say the inclusion may see some pre-positioning from global investors as large investors are already holding 2-3 percent of their funds in IGBs or India risk. Passive index funds are unlikely to start including IGBs until closer to the inclusion starting date, while active funds have tracking error limits as they are not able to get to the full 10 percent now, says Nomura. They expect $23.6 billion of bond inflows over the inclusion period, which may not be released straight away.

According to Axis Mutual Fund, once noise around US Federal Reserve’s rate hikes and global yields stabilises, peak market rates will be behind us and market yields could gradually soften. “From a demand perspective, markets could see incremental buying from active foreign funds. That would probably be less than $5 billion before the index inclusion,” it says.

However, as Brent crude prices have been over $90 per barrel, oil prices remain a wildcard. “With crude prices spiking to $95, markets are likely to bake in some degree of pessimism into the Indian bond markets. However, the two aspects could negate each other over the medium term,” says Axis MF.

How will JP Morgan include Indian government bonds?

On Friday, JP Morgan announced that IGBs will be included in its EM bond benchmark, with 73 percent of investors in favour of the decision. Since 2021, India has been on index watch positive or inclusion into the GBI-EM, following the Indian government’s introduction of the FAR programme in 2020 and substantive market reforms for aiding foreign portfolio investments.

The inclusion, which starts from June 28, 2024, will be in a staggered manner. A 1 percent weightage per month over a total of 10 months (through March 2025) will be added, before India reaches the maximum weighting of 10 percent in the GBM-EM GD index.

There are 23 IGBs currently meeting the Index eligibility criteria, with a combined notional value of about Rs 27 trillion or $330 billion. Only IGBs designated under FAR are Index-eligible. As a result, India’s weight is expected to reach the maximum weight threshold of 10 percent in the GBI-EM GD, and about 8.7 percent in the GBI-EM Global index.

As per the Index-inclusion criteria, eligible instruments are required to have notional outstanding above $ 1 billion (equivalent) and at least 2.5 years remaining till maturity. At the start of the inclusion on June 28, 2024, only FAR-designated IGBs with a maturity date after December 31, 2026, will be assessed for eligibility. Any new Index-eligible FAR-designated IGBs issued during the phase-in period will also be included.

JP Morgan says inclusion of FAR-designated IGBs in the GBI-EM Global/Diversified indices is estimated to increase index yields by 33 bps and 8 bps, respectively, upon completion of the staggering process. The duration for GBI-EM Global and GBI-EM GD is expected to extend by +0.19 years (to 5.34) and +0.24 years (to 5.22), respectively.

Currently, India has a local currency debt rating of BBB- / BBB- / Baa3 by Fitch, S&P and Moody’s respectively. India is expected to have a weight of 14.59 percent in the Index, which will be phased in over the 10-month period.

Also read: Why global bond yields have risen again and how they may affect the rupee

Will it nudge other global indices?

The FTSE Russell index review is still pending on September 28, but several factors have contributed to optimism about India's inclusion. IGBs are on the watch list for inclusion in the FTSE EMGBI Index and they qualify for inclusion in the Bloomberg Global Aggregate Index.

Pranjul Bhandari and Aayushi Chaudhary, economists, HSBC, believe that for India to enjoy long-lasting benefits of index inclusion, two pre-conditions must be met: Inclusion in various bond indices over time, and easier operational access to the Indian bond market.

“If inclusion in the Bloomberg Global Aggregate Index [BGAI] is announced in the coming months, it could be meaningful as a possible weightage of 0.6-0.7 percent in the index [based on the amount of outstanding bonds], could lead to $12-14 billion in inflows on operational ease; there are lingering issues around settlement and repatriation, which can be addressed,” Bhandari and Chaudhary say.

Analysts at Nomura agree that JP Morgan’s decision make it more likely for Indian bonds to be included in other global indices. “Over the longer term, this could trigger other index inclusions, such as in the Bloomberg Global Aggregate Index [likely in Q1 2024], which could attract another $7-10 billion of inflows. As for the FTSE WGBI index, India remains too low-rated,” Nomura explains.

However, Bajoria doesn’t seem to be convinced. “Still, India's prospects of getting into other major bond indices, namely the Bloomberg Global Aggregate Index and the FTSE Russell World Government Bond Index, remain low, in our view, as they need Euroclear-ability for settlement and a higher sovereign credit rating, which India does not appear close to,” he adds.

Mittal echoes that the JP Morgan decision does not immediately pave the way for inclusion in the FTSE and Bloomberg indexes, which have more stringent conditions but could have a demonstration effect in the medium term as the lower risk premia could trigger positive externalities.