India’s decisive election outcome has created the potential for further structural reform that could result in a near 7 per cent GDP growth rate over the coming decade, and bank capital injections could enable banks to facilitate funding for that growth.
This would have meaningful implications for India’s fixed income markets. We believe the next decade for India’s foreign exchange (FX) and fixed income markets will be marked by policy-driven reforms driving accelerated growth with increasing market liberalisation.
Recent figures already appear more encouraging than the dynamics that have been supporting stagflationary recession conditions: The country’s balance of payments has improved, spurred by FX depreciation and the Reserve Bank of India’s (RBI’s) non-conventional measures. The growth outlook has turned moderately positive, helped by a global recovery; and bad loan formation, even at state-owned banks, may now be moderating.
The narrative for Indian markets began to brighten even before the elections.
Following the second stage of India’s economic liberalisation and the foreign direct investment (FDI) reforms initiated in September 2012, foreign investment will likely be a major contributor to a jump in private investment. However, despite liberal FDI limits, it has remained moderate, constrained, in part, by administrative hurdles.
As the obstacles are reduced, we expect FDI to lead an investment boom over the next decade, similar to China’s mid-1990s experience. We project FDI will rise to an average of 2.5 per cent of GDP (FY2014-24) from an average of 1.5 per cent of GDP (FY2008-14). We believe such foreign capital flow will lend significant support to India’s balance of payments trajectory.
Import growth pace to rise
India’s economy remains domestically oriented and a net importer. We expect the import growth pace to rise as domestic growth recovers and the government revokes extraordinary restrictions on imports and outward remittances. The service sector has been the major source of export income, as India’s market share in global services has risen by 2.5x over the past decade.
Over the long term, we think India is likely to maintain a stable net current account deficit of about 2.5 per cent of GDP. This is close to the historically sustainable level of deficit of about 2 per cent of GDP. We expect the positives of FDI inflows, against the offset of a widening current account, to drive the currency path, resulting in a stable real effective exchange rate (REER) path — but a weaker nominal path, curbed by India’s high inflation differential against its major trading partners.
Although there is a positive historical correlation between India’s balance of payments flows and the change in the Indian rupee real effective exchange rate, the RBI is likely to remain a long-term buyer of US$/rupee, absorbing a significant portion of the net capital inflows. Adjusting for RBI interventions, we expect a stable REER to be maintained within +/-1 standard deviation over the long term.
Assuming that US CPI (consumer price index) inflation remains close to its target of 2 per cent per year, and India follows a disinflationary path over the next few years, the inflation differential against the US would still be equivalent to a 30-35 per cent decline in the PPP fair value for the rupee, taking our nominal fair value estimate 10 years out to a 75-85 range.
We expect India’s credit markets to triple in size by 2019, partly reflecting growth and capital needs, but mostly increasing reliance on debt capital markets. India could become the second-largest G3 bond issuer in Asia, reaching the $160 billion mark by 2018 — with $100 billion worth of bonds from non-financial corporates (as their reliance on capital markets grows from a very low base) and $60 billion worth of financial bonds. The Indian US$/G3 bond market, on average, should see annual gross issuance in excess of $30 billion by 2018, up from our $16 billion 2014 forecast.
On the interest-rate front, local bond markets may benefit from a successful fight against inflation and potential relaxation of foreign investor limits, but real yields will also have to rise to ensure a stable savings rate and to reflect stronger growth.
A positive surprise for Indian interest rates markets could come from potential inclusion in the global bond indices. We believe that if India considers inclusion in the global indexes, it is likely to get the maximum weight in most indices, given the large market capitalisation of $600 billion of its government bond market.
We estimate the initial impact of such a move could prompt foreign investor inflows of US$20-30 billion for India’s bond market.
Finally, we expect India’s sovereign rating to remain unchanged in the near term. Any upgrade would require considerable improvement in inflation, fiscal balance and current account.
— The writer is the head of Asia Fixed Income Research at Morgan Stanley.