Inclusion of Government Bonds in Global Indices to Provide Further Support for India's Stable Currency Amid Economic Growth
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Inclusion of government bonds into global indices to provide further support
Along with a consistent inflow of foreign direct investment, the category “other investment,” makes up much of India's financial account inflow. This category is made up mainly of American and global deposit receipts (ADR and GDRs) and shows that overseas equity listings have been a reliable source of foreign exchange receipts over the last 18 months.
Portfolio flows have been more erratic, as one would expect, but the direct and “other” investments should be fairly sticky, which is a comfort when a currency is artificially held away from where the market would like to take it for some time, and where the trade picture looks challenged.
Looking ahead, the recent announcement that JP Morgan will include Indian government bonds in its Emerging Market Bond Index, from 28 June next year, will support further portfolio inflows. This move has been long-awaited after being delayed several times in recent years. Estimates vary, but substantial inflows of foreign capital of between $25-40bn are thought likely to be attracted to Indian government bonds as a result.
It remains to be seen whether the JP Morgan decision will spur others, such as the FTSE Russell to follow suit. Either way, as well as supporting the INR, the decision should also help to reduce government bond spreads over US Treasuries, and also pass through into lower corporate bond rates.
That said, with US inflation heading lower over the next year and Indian inflation likely to stabilise at something around the 4%-4.5% level, we would expect the INR to eventually resume its trend nominal depreciation at about a 2% annual rate in line with maintaining a stable real exchange rate, after first benefiting in the short term from a shift in market expectations for US Federal Reserve rates to price in more easing in 2024/25.
With the currency currently supported in a narrow range, and not having seen the amount of depreciation evident in other regional currencies, we think that the scope for some INR appreciation when the USD finally does turn weaker is more limited than some other currencies, and we’d expect to see the Australian dollar and Korean won doing better if this turn ever does materialise.
Inflation and the Reserve Bank of India
Earlier this year, Indian inflation came down within the RBI’s inflation target range of 2-6% and looked as if there might be scope for policy rate easing before the end of the year. But erratic monsoons have hit agriculture and pushed up seasonal food prices sharply, and that has lifted inflation back above the RBI’s target, though it is beginning to ease lower again now.
We expect inflation to keep moving lower over the second half of the year, as the government shields households from rising energy prices, and we could see inflation back within the inflation target as soon as next month, and close to the mid-point of the target with the release of October data.
India's inflation and rates outlook
That will keep real rates elevated and will make a strong case for some reduction in rates in early 2024. At 6.5%, India’s policy rate spread over the US is 100bp, which is helping support the INR. That is a bigger spread than some of its Asian peers. The main risk to our rates outlook is if the US economy continues to defy logic by failing to slow, keeping the USD strong.
India is delivering very solid economic growth currently, and there isn’t much in the current run of data to suggest that this shouldn’t continue to be the case. Inflation has spiked higher and that means that we probably aren’t looking at an immediate easing of policy rates and indeed, this will probably not take place until next year. That said, and notwithstanding what is obviously some direct support for the INR from the Reserve Bank of India, the support for the currency from overseas direct investment and equity listing would probably have seen the INR outperform its peers anyway and will take a further boost from the inclusion of Indian government bonds into global bond indices next year. That also removes an impediment to eventual easing, where some other regional peers are deliberately keeping policy tight despite better inflation credentials to offset currency weakness.
2023 should see the economy return close to a 7% growth rate overall, a return of inflation within the RBI’s target range, and sow the seeds of some policy rate easing in 2024, which will help underpin strong growth for another year.
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