Global bond market indices still exclude India, but the country could take its place in the benchmark in 2022—with far-reaching implications for bonds and beyond.
India has one of the world's fastest-growing economies and a population second only to China. But you wouldn't know this looking at global bond indices. Unlike most major emerging markets, India has no presence on any of them.
The market consensus holds that India will be added—eventually—pending unanswered questions around timing, implementation and size. Morgan Stanley Research has a different take: Its economists and strategists believe that global-bond-index inclusion is imminent.
“India has made significant strides in macroeconomic stability, and its government is more motivated than ever to encourage corporate-investment-driven growth," says Chief India Economist Upasana Chachra. “We think India will be included in two of the three major global bond indices in early 2022."
Beyond the direct benefits of index inclusion—it could trigger $170 billion in bond flows over the next decade, lifting Indian bond prices while lowering borrowing costs—this milestone could have profound implications for the country's currency, corporate bonds and equities.
“India would be the last major emerging-market country to join the global bond indices, following China's path two years ago," Chachra says.
Here are four implications of global-bond-index inclusion for India, and why it could signal the emergence of a new India.
Major indices don't simply track their respective markets—they influence them. When an index adds new constituents, portfolios pegged to those benchmarks must adjust their allocations accordingly. “India's inclusion would trigger significant index-related inflows, followed by an allocation from active global bond investors," says Min Dai, Head of Asia Macro Strategy.
For example, if added, India could represent 9.2% of the JPM GBI-EM Global Diversified Index, making it the second-largest country in that benchmark, after China.
In its base-case outlook, Morgan Stanley estimates that $40 billion would flow into Indian government bonds following inclusion into 2-of-3 global indices —Bloomberg Global Aggregate Index and JPM GBI-EM Global Diversified Index—with $18.5 billion in annual inflows over the next decade. This would push foreign bond ownership, currently less than 2%, to 9% by 2031. As more foreign capital flows into Indian government bonds, the yield curve—or difference in short-term and long-term yields—could flatten by 50 basis points, or hundredths of a percentage point.
Index inclusion, while significant on its own, would also signal policymakers' desire to support higher economic growth through investment. “This will push India's balance of payments into a structural surplus zone and indirectly create an environment for lower-cost capital and, ultimately, be positive for growth," says Chachra, adding that India's consolidated deficit could shrink to 5% of its GDP by 2029, down from 14.4% for the 2021 fiscal year.
India’s currency would also feel the impact. The shrinking deficit could bolster the value of the Indian rupee by 2% a year against a basket of other major currencies, in exchange rate terms. While India's long-term 4% annual inflation would imply a 2% depreciation in the value of the rupee in nominal terms, at around a 6% yield, Indian government bonds could offer investors medium-term returns of around 4% in dollar terms, “which is quite attractive for foreign investors," says Dai.
Inclusion in global bond indices could also help Indian corporations with their capital needs. When foreign capital flows into government bond markets, it lowers overall borrowing costs, improves debt sustainability and also drives demand for other—read corporate—fixed-income securities. That's potentially good news for India's domestic corporate bond market, which foreign investors have largely overlooked.
Foreign ownership of central goverment bonds*
Given its status as Asia’s second-largest economy, “India is 'punching below its weight',” says Dai, noting that India’s corporate-bond-market size as a percentage of GDP is closer to much smaller countries like Thailand and the Philippines.
Foreign investors would gain access to a significantly larger pool of Indian corporate issuers. To put it in stark terms: The closely followed universe of dollar-denominated offshore Indian corporates comprises 57 issuers, while India’s domestic market has nearly 2,000 issuers, half of which still lack a credit rating, all of which gives potential investors many more opportunities to spot mispriced bonds.
History suggests that index inclusion can help bring domestic-only corporates out of obscurity. “We think that India's current situation is similar to China in 2017, when it started opening its onshore bond market to foreign investors," says Dai. “As ownership of Chinese government bonds increased, we also started seeing an increase in foreign ownership in the China onshore corporate-bond market."
The opening of India's sovereign bond market may also bode well for equities, which stand to benefit from lower borrowing costs and a healthier macroeconomic backdrop. Among these, large private banks could be the most obvious winners. Still, nonbank financials— such as those focused on mortgages, credit cards, insurance and asset management—could enjoy the spillover effects of a more robust bond market in India.
For more Morgan Stanley Research on India's bond markets, ask your Morgan Stanley representative or Financial Advisor for the full report, “The Next India: The Transformation of India's Bond Flows" (Sep 8, 2021). Plus, more Ideas from Morgan Stanley's thought leaders.