As political revolutions sweep through the Western world, a quieter revolution is unfolding in southern Asia. India’s transformation into a dynamic, 21st century economy has created a fantastic opportunity for international bond investors.
The Big Picture
Today, India stands as the world’s seventh largest economy and is currently the world’s fastest growing major economy. The government and central bank have managed the economy well and reforms are rapidly improving India’s infrastructure and the way business is done.
And the best is yet to come.
Strong fundamentals – and getting stronger
In recent years, India’s balance of payments situation has strengthened considerably. The country’s current account deficit has fallen consistently over the last three years, standing at 0.8% in 2016 from 4.8% in 2014. The government’s policy to open up the economy has led to substantial improvements in foreign direct investment (FDI). Foreign exchange reserves of some US$372 billion are at record levels.
Equally important has been the government’s efforts to reduce the fiscal deficit and debt accumulation.Note: New CPI series from Feb 15 onwards, base year updated to 2012 from 2010 and weights for food and fuel lower.
Source: CEIC, Bloomberg, Dec 16. For illustrative purposes only.
India’s fiscal position is particularly important because of its impact on the country’s credit rating, a critical factor for bond investors. But, unfortunately, the rating agencies appear to be behind the curve – again. They have criticised India’s debt levels, and yet its debt-to-GDP is not particularly high – latest figures put it at 66%. Foreign currency denominated debt is also low, particularly relative to other emerging markets and versus India’s foreign exchange reserves, which cover almost 10 months of imports.
Investors, on the other hand, recognise that the outlook for India has improved and the foundations for continued reform in the economy have been laid.
RBI maintains credibility
No less impressive than the Modi government’s efforts to balance India’s books have been the India’s central bank’s pro-active approach to monetary policy.
The appointment of Urjit Patel as governor and the establishment of the monetary policy committee signalled a continued commitment to inflation-targeting and adherence to monetary policy discipline that was initiated by previous governor, Raghuram Rajan.
Thus far, the policies have been effective with inflation falling well within the RBI’s 4%+/-2% target despite several food price shocks resulting from back-to-back droughts. This allowed the RBI to cut rates five times in 2016. The repo rate is currently 6.25%. And among other things, the move to a marginal-cost-of-funds based lending rate (MCLR) has significantly improved the transmission of policy, with banks’ lending rates beginning to decline fairly significantly.Note: New CPI series from Mar 15 onwards, base year updated to 2012 from 2010 and weights for food and fuel lower.
Source: CEIC, Aberdeen Asset Management, Dec 16
The progressive reforms enacted by PM Modi, elected in May 2014 have been a game-changer. More than 50 reform bills have been passed under Modi’s premiership.
Of particular note is the Bankruptcy Bill, approved in May 2016, which cuts the time taken for companies to declare bankruptcy from four years to about 12 months. The passage of the Goods and Sales Tax (GST) was another major step forward in improving compliance and revenue collections, allowing the free flow of goods and services between states. These reforms have established a clear framework for states to improve their efficiency and competiveness.
Notably, the government has begun the process of devolving power and central resources to the states, thus increasing their share of central tax revenue from 32% to 42%. On reform progress, although no state has reached the government’s desired score of 75%, the large majority are making inroads.
Source: World Bank & Indian Department of Industrial Policy and Promotion, 2015
Another innovation has been the development of ‘Aadhar’, a cloud-based identification system which uses a fingerprint and iris scan, name and other details to uniquely identify every Indian citizen. The benefits are numerous from improving people’s access to cheap credit to helping businesses better serve and understand their customer base and reducing fiscal slippages due to corruption.
Most recently, in November 2016, the government announced the replacement of old Rs500 and Rs1000 bank notes with brand new Rs500 and Rs2000 notes in a valiant bid to reduce black money and corruption, and widen the tax base. The sudden nature of the so called demonetisation was criticised in the press, but it was never going to be easy in a country with a massive informal economy. Nevertheless, it was another indication of the Modi government’s willingness to make tough decisions.
Despite the controversies surrounding demonetisation, Modi’s BJP won the Uttar Pradesh (UP) state election in March 2017 in remarkable style, taking 325 of the 403 seats available – the largest margin of victory for any party in UP since 1980. UP is India's most populous state with 204 million people. The next federal election is in 2019 and this win will give Modi, his BJP party and the financial markets greater confidence that he will serve a second term as India's Prime Minister.
Underlining all this progress has been streamlining and improvement in government productivity and decision-making. Technology has been instrumental, allowing greater scrutiny over the performance of ministers and ministries and making tedious processes like setting up a new business and paying taxes much faster and easier. Projects are tracked with deadlines and there is far more accountability than previously.
The aggregated impact of these reforms have driven a rapid increase in India’s global competitiveness since 2014, as can be seen in the chart below from the World Economic Forum.
*Global Competitiveness Index. Each column represents the change with respect to the previous Global Competitiveness Index.
Source: World Economic Forum, The Global Competitiveness Report, Dec 2016
Benefitting from Indian Bonds
For current and potential bond investors, the improvement in India’s political and economic backdrop is very welcome news. And looking at how India’s bond market has matured, the picture becomes even rosier.
The bond market has quadrupled in size over the last decade meaning it is now the second largest bond market in Asia. Corporate bonds now make up about 25% of the overall bond market and are among the most liquid in Asian markets.
Indian bonds had a stellar year in 2016 – yields fell by 100-120bps across the curve. There are several factors that should propel the rally further over the coming quarters.
Inflation has continued to fall to new multi-year lows at 1.5% in June 2017, which is well below the medium-term RBI target. There is room for at least one more rate cut, however the timing and indeed the depth of the easing cycle from here is made difficult due to uncertainty around the path for inflation moving forward. Inflation should begin to normalize, however the central bank and market has persistently overestimated inflationary pressures. Longer term, local currency Indian bonds should benefit from a structural decline in inflation and a more stable rupee as reforms are fully implemented and India's sovereign rating is belatedly upgraded.
Indian bond yields remain compelling, particularly when compared to the record low-yields we have seen in the US and Europe. The 10-year nominal Indian government bond yield is around 6.5% and real yields are also very attractive. Highly-rated quasi and corporate bonds offer a pick-up of 40-80bps and 55-100 bps respectively over government bonds.
The global economic backdrop only strengthens the case for Indian bonds. India’s transformation is very much a domestic growth story, in contrast to China’s, for example. Indian’s economy has a low correlation to international markets and this extends to Asia – Bank of America Merrill Lynch finds that the average correlation of Indian bonds to the rest of Asia has been close to zero since 2014. Indian bonds thus offer a great source of diversification for international bond investors.
What’s more, liberalisation of India’s bond market has given foreign investors greater access to Indian bond trading platforms. This was one of initiatives implemented by the RBI to help grow India’s corporate bond market and it has arguably ended lethargy in the sector. We expect foreign ownership of Indian bonds to continue rising.
So the prospects for Indian bonds look very bright. Investors across the world are starting to open their eyes to the India story.
Kenneth Akintewe, Senior Investment Manager, Fixed Income
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