On 21 Sep, JP Morgan’s index team announced that Indian Government Bonds (IGBs) will be included in the Global EM local currency government bonds index (GBI-EM) from June 2024. IGBs have been on a positive watch list of GBI-EM index since 2021 following government’s introduction of the FAR (Foreign Accessible Route) program in 2020.
We don't expect this inclusion to necessarily translate into a near term inclusion in other larger global benchmark indices. Estimated foreign flows of ~25bn$, phased over 10 months starting Jun-24-23 bonds, with a notional market cap of 330bn$s, are deemed to be eligible for this inclusion. As such, IGBs are expected to reach the maximum threshold of 10% in the GBI-EM Global Diversified Index and 8.7% in the GBI-EM Global Index. With GBI-EM’s tracking AUM of about 240bn$s, India would potentially record about 25bn$ of foreign portfolio flows. This inclusion, however, would be phased over a 10 month window from June 28, 2024 till March 31, 2025. That would translate to 2.5bn$/month flow.
India’s portfolio inflows would be funded by a diverse list of countries as indicated in Figure 4, with largest hit estimated to be to Thailand (-4bn$), South Africa (-3.4bn$), Poland (-3.1bn$), Czech Republic and Brazil (-2.4bn$ each). Given the phased inclusion, we expect minimal collateral damage.
With actual inclusion nine months out, and staggered over a ten month period, we expect a negligible near-term market impact with even pre-positioning flows unlikely this year. In fact, given market's preparations for this event in the past few weeks, we expect near-term profit taking in the NDOIS/IGBs' as market focus shifts back to food inflation concerns/El Nino, DM fixed income sell-off (IN-US 10y yield spread at 15+y lows) and potential risks of pre-election fiscal spending; we retain 1s5s NDOIS steepeners view into October. That said, we do expect this inclusion to keep the term premia depressed in FY25 by when inflation base-effects/DM monetary policy cycle would also be supportive. We lower 10y yield forecast for 2024 from 7.0% to 6.75%.
Just like IGBs and NDOIS, we expect negligible near-term impact on rupee. In fact, with this announcement being an anticipated event, we recommend fading the dips in USDINR while targeting a potential move towards 84.50 within next couple of months.
Even before the recent oil price moves, India's CA balance had deteriorated to ~2% of GDP deficit (2mma as of August). Taking oil price shock, muted FDI flows and recent portfolio flows into perspective, we estimate the broad basic balance deficit potentially hitting 2.5-3% of GDP
Ongoing global risk aversion, and non-negligible expensiveness of Indian equities, could potentially catalyse partial profit taking of record YTD equity portfolio flows (of 15bn$s) - a phenomenon that INR has not observed in more than six months. CNH/INR's ongoing decline towards 2022 lows could potentially spark a policy induced FX reset, especially with RBI's 40 currency REER hitting ~90th%ile of 5y range.
We concur with RBI's opinion that the benefits of index inclusion appear to outweigh the concerns associated with it. 1) this inclusion would likely push the government to adhere to fiscal consolidation path to ensure India maintains IG rating. 2) amidst India's trend CA deficit of 2% of GDP, foreign portfolio inflows would be a welcome development to ease external balance concerns. 3) these flows would help to diversify the IGBs' investor base, while potentially lowering government's debt financing bill without risk of crowding out by the government.
That said, a one shot flow is unlikely to be enough on its own. A durable impact is only likely if other bond indices also include India, for which rationalisation of capital gains tax might be a necessary condition.
Equities: Minor tailwind, valuations still stack up expensive. Historically, a 10bps drop in IGB yields has normally meant a 0.40x increase in Nifty PE multiples (currently trading at 19x 12M forward). When seen in the context of 1) already tight equity risk premia with Indian equities trading 1SD above 10 year average relative valuation to India bonds, and 2) Indian equities trading in their top 84th percentile relative to MSCI EM, this tailwind from bond inclusion is negligible. Direct flow through could be higher for financial sector (SLR holdings for banks, and wholesale funded banks and NBFCs).
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