Markets & Economy
Global Fixed Income
Reform Momentum Opens Up Indian Bond Market OpportunitiesMarch 30, 2017
- Recent reforms implemented by Prime Minister Narendra Modi’s government in India have created an attractive opportunity set in the country’s bond market for international investors.
- India’s long-term disinflation trend and positive growth trajectory have also contributed to a positive environment for bond investing, while the market is gradually opening up to overseas investors.
- Indian government bonds may offer strong diversification benefits and have a higher yield than the bonds of many Asian peers, which are not on such a positive reform track.
- It is important to be mindful of a number of challenges including India’s significant bad debt problem and its myriad political risks, which could obstruct further development of the market.
India’s bond market has not always been a high priority for investors in emerging market debt. The perception that it is somewhat opaque and difficult for overseas participants to access has deterred many from exploring the market. But the Indian fixed income space has been gradually opening up to international investors in recent years, while a more attractive opportunity set has arisen on the back of the country's long-term disinflation trend, its positive growth trajectory, and the reforms implemented by Prime Minister Narendra Modi’s government.
Despite this progress, however, potential investors in Indian bonds will also need to consider the hazards posed by the country’s significant bad debt problem and its myriad political risks before embarking on what is still a relatively untrodden path.
The Indian bond market has traditionally been a largely domestic affair, with comparatively low levels of international investment, as regulation has restricted overseas investors looking to access the bond market to using interest rate swaps and foreign exchange as proxies. While access to overseas participants has started to improve in recent years as the Indian government has sought to open up the market to international investors, there are still limits on the amount of Indian bonds that foreign investors can hold.
For international investors who have been able to gain access to the Indian market, it has been worth the effort. Indian government debt has performed relatively strongly since 2014, with yields on 10-year bonds declining from around 9% to less than 7% between early 2014 and late 2016 on the back of falling inflation and easier monetary conditions (see Figure 1). The government’s recent demonetization of certain high-denomination Indian rupee bank notes to crack down on the shadow economy has also fueled expectations of weaker growth and lower inflation following the large inflow of deposits to banks. This has further boosted bond prices, which are now more stretched than they were two to three years ago.
However, while valuations are not as attractive as they have been, there are still a number of factors in favor of investing in Indian debt.
The currency itself also might be interesting to investors. The balance of payments is in strong shape with a low current account deficit and solid foreign direct investment inflows. The rupee seems reasonably valued, and we believe it has advantages over other Asian currencies given India’s strong growth and clear path to structural reforms, and the higher yield available on Indian debt.
High inflation in particular historically has been a burden on India’s bond market, and it is here where reforms have had the most pronounced impact so far. Following the financial crisis of 2007–2008, India went through a period of double-digit inflation, driven partly by monetary stimulus measures implemented by the Reserve Bank of India (RBI), whose primary focus had not traditionally been to control rising prices. Then in 2013, newly appointed Governor Raghuram Rajan made it a priority for the RBI to bring inflation down, and under his watch it subsequently fell into single-digit territory. The accompanying decline in nominal interest rates created an attractive environment for bond investors.
In addition to the implementation of a formal inflation mandate, the RBI has also put in place further reforms designed to institutionalize the central bank’s policymaking process, including the creation of a monetary policy board to set interest rates (the responsibility for setting rates previously rested solely with the governor). This has further strengthened the central bank’s incentive to remain focused on inflation in the longer term and has been a boon to fixed income investors, who typically prefer central banks to be as independent as possible. The RBI’s establishment of the monetary policy committee (MPC) and new inflation targeting mandate have helped to put India at the forefront among emerging markets in terms of pushing toward more independent monetary policy.
This progressive approach looks set to continue. Rajan stepped down as RBI governor at the end of his first term last year and was replaced by former Deputy Governor Urjit Patel, who authored the initial report recommending the establishment of an MPC and an inflation target. Under Patel’s leadership, the RBI is expected to adopt a similar stance as it did under Rajan. The RBI’s more institutional approach will also mean that the governor has less personal influence on policy than in the past.
While there are challenges ahead, notably in the form of political risk and high levels of debt, the trend of opening up to foreign investors looks set to continue.
India has also undertaken multiple reforms to reduce the size of its black market economy. In addition to the currency demonetization program discussed above, they have also introduced measures to reduce red tape around infrastructure spending and property development.
Another key reform that is potentially highly supportive for fixed income investors is the creation of a nationwide goods and services tax (GST). The GST removes certain barriers and tax distortions between states, with the aim of making India a more efficient internal market. It will probably not raise significant amounts of revenue for the Indian government at first but should be beneficial for growth over the longer term by simplifying the country's disjointed tax system and creating a genuine single market.
While government influence over the RBI has been reduced, political risk nevertheless poses other threats to the development of the country’s bond market. Even though the government has a commanding majority in the lower house of parliament, it does not control the upper house, making it more difficult for it to pass legislation. This could be a roadblock to the government’s ambitious reform agenda.
Furthermore, Modi’s government has entered the second half of its term, prompting concerns that it could focus more on short-term populist measures to raise its chances of reelection, such as offering loan waivers to certain groups, and less on enacting lasting legislation. More generally, Indian politics is gradually moving from a system dominated by a central party to one characterized by a number of smaller, regional parties. This again makes it more difficult to bring about significant reforms in the longer term.
India’s bond market also faces several economic challenges. The country has a number of large conglomerate groups that are overleveraged—the top 1% of companies accounts for around half of the overall debt, according to the International Monetary Fund. There is also a large amount of debt in the country’s banking system. The establishment of the country’s first national bankruptcy law, passed last year, was intended to create a process to address this level of debt. However, while the law is widely considered a positive development for investors, it will likely take several years to develop the institutions and judicial expertise to effectively implement before investors begin to feel its benefits. Spending on fixed assets is lagging too: India’s investment-to-gross domestic product ratio has been falling for a number of years, which is a concern for potential international investors.
Even so, Indian bonds may offer diversification potential for international investors. The market is less exposed to forced selling than some emerging market peers during periods of risk aversion, owing to the small proportion of overseas participants. Furthermore, the market has a fairly low correlation to U.S. Treasury bonds. Typically, any large swings in U.S. Treasury yields have a spillover effect on global and emerging market bond yields. Indian yields, however, can be less susceptible to these than other emerging markets. One example of this came in the immediate wake of the U.S. presidential election in November, which coincided with the government’s aforementioned demonetization program. While yields on U.S. Treasuries and many other government bonds climbed by up to 40 basis points in the days following the election, Indian government bond yields actually fell.
More broadly, the country is gradually moving toward a more open, inclusive market in global terms, which should ensure that the demand for Indian assets will rise structurally over time, against what is currently quite a low base, particularly in the fixed income and foreign exchange space. What’s more, Indian government bonds have a higher yield than the bonds of many Asian peers, which are not on such a positive reform track.
This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.
The views contained herein are those of the authors as of March 2017 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.
This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.
Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.
Past performance cannot guarantee future results. All investments involve risk. All charts and tables are shown for illustrative purposes only.
T. Rowe Price Investment Services, Inc., Distributor.
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