The Continuity Assumption: A Bond and Macro Update

The Framework

To recap, there are four key reasons why we judge that the Indian bond market is in a structural phase:

1. A Steady Improvement in Our Macro-Economic Dynamics

   Let's delve deeper into the three large pillars that define macro-economic stability:

   a. Current Account: The primary variable contributing to the substantial narrowing of our current account deficit (CAD) is the USD 5 billion per month increase in net services trade surplus over the past three years. This can be visualized as local savings being boosted by offshore income. Despite steady growth and stable commodity prices, India has managed to sustain approximately a 1% CAD.

   b. Fiscal Deficit: The government has been measured in fiscal expansion over the pandemic and has subsequently undertaken rapid fiscal consolidation. This has been driven by robust expenditure management combined with a steady improvement in expenditure mix. Additionally, revenue buoyancy has improved with better compliance and the so-called ‘J’ curve on GST presumably kicking in. Thus, the consolidation seems much more sustainable both from the standpoint of intent and ability.

   c. Inflation: Inflation targeting is now entrenched in RBI policy, and the central bank has behaved like a conventional inflation-targeting bank should. The pandemic easing was well thought through, and the subsequent tightening was proactive. Even now, with inflation skewed largely towards food items, the RBI remains vigilant for second-round effects. Additionally, forex management has been adept with a focus on building reserve buffers whenever the opportunity presents itself. On its part, the government has been proactive in supply-side management of food to the extent possible.

2. The Scale of the Indian Economy

   The India macro-economic story is backed by an economy that is now too large for global investors to ignore. Put another way, India is no longer a ‘side-story’ that can be side-stepped by large global institutional investors. We are already the 5th largest economy and are soon to hopefully become the 3rd over a reasonable forecast horizon.

3. Bond Index Inclusion

   The bond index inclusion has a direct flow impact of approximately USD 25 billion. Alongside being one of the best global macro stories and now at a scale that can't be ignored, the index inclusion is just the nudge needed for global fixed-income investors to set up apparatus for taking exposure to Indian fixed income, whether directly or indirectly. Subsequently, the strength of the narrative would dictate the quantum of flows that happen over the next few years. The potential here looks substantial to us.

4. The US Macro Story and Its Implications

   The US macro story is now dominated by fiscal exceptionalism. This was evident both in aggressive expansion as a pandemic response and the unwillingness to consolidate now. Indeed, the approximately 6% government deficit is expected to sustain for years into the future. If this is happening at the current above-trend economic growth rate, one wonders what happens if growth starts to slip below trend. Thus, a combination of a high fiscal deficit and high CAD is almost baked into the assessment of the US macro. This is slowly leading to a ‘de-premiumization’ of dollar assets, most evident in narrowing yield spreads between US bonds and those of other better-run macro-economic geographies. It is possibly also partly responsible for the sustained demand in gold lately, despite US cash rates being this high. Alongside, due to sharper definitions of geopolitical blocks and associated tariff wars, there is a heightened urgency for participants in said blocks to start to de-dollarize, at least partly. This has led to more talk of bilateral trade settlement in local currencies. Taken together, these factors have potentially set the dollar on a long-term depreciating trend, even as this is likely to be interrupted from time to time for cyclical reasons. Thus, portfolio investors have more incentive to diversify into other large, well-run markets. We think India is likely a direct beneficiary of this developing phenomenon. Related to this, one hears more and more investors wanting to take unhedged exposures to Indian assets with a view that the annual cost of hedging probably overstates their expectation of rupee depreciation in the years ahead.

We believe the four factors above constitute a powerful confluence, making a strong case that India fixed income’s ‘time has come.’ A notable component of this view is the assumption of policy continuity. This is because, as discussed above, a lot of the macro-economic consolidation India is experiencing is not due to serendipity but to concrete policy intents and actions.

Risk Assessment

Given the above, it is important to assess whether the continuity assumption holds. More precisely, one has to assess the extent to which it does:

1. Full continuity
2. Some dilution that keeps the underlying story largely intact
3. Dilution enough to reconsider the underlying framework.

From a bond market standpoint, the direct change to potential policy continuity can happen in the following ways:

1. A notable change in direction on fiscal consolidation, most likely accompanied by a deteriorating expenditure mix. This will put pressure on both inflation and CAD (as the extent of reduction in government dissaving going forward gets compromised or reversed, assuming households and firms remain status quo on this account).
2. Other policy measures that appreciably lift the general level of inflation, such as a substantial and recurring rise in minimum support prices for agricultural procurement.

Then there are other indirect changes that may impact the robustness of revenues, and perception as an offshoring/investment destination, etc.

In order of certainty, we are most certain that the institutionalized focus on inflation management continues. Next, it is quite unlikely that a somewhat weakened government mandate is enough grounds to seriously impact the uptrend witnessed in the services trade surplus. For example, it is highly improbable that India stops being seen as a preferred destination for global capability centers.

This still leaves the important point about fiscal consolidation on the table. Again, we have seen enough commitment thus far towards fiscal prudence to consider a serious change in trend. That said, some change in spending mix and a slower path of consolidation may very well still be in the offing. For example, the market may assume that most of the additional dividend bounty from the RBI may now be channeled towards dialing up revenue spending. However, the magnitude of such change needs to be tracked and a few basis points (as a % of GDP) addition to spending may eventually not matter much. At any rate, the union budget in July will now have extra significance since it will allow the market to assess whether there has been any meaningful rethink in the fiscal approach under the new mandate.

Going Forward

In our view, it is important to appreciate that the factors underpinning India’s bond attractiveness, as described above, are strong enough that they shouldn’t be discarded lightly. Thus, a marginal dilution in direction can be very easily absorbed without changing the underlying narrative much. As of now, that is all we would expect anyway since this is continuity of the same policy thought essentially but with some additional considerations potentially thrown in. Also, the list of short-term bond positive factors is large enough for us to take time for the full union budget to be presented where one can hopefully get full confirmation that the assumption of continuity holds. Among these short-term factors are a cut to local bond supply for the first half of the year, the upcoming start of index inclusion, as well as recent weakness in US data that has the potential to take global pressure off yields (although it must be said that US data has tended to be pretty volatile).

All told, then, we continue to hold our underlying thesis with the following considerations in mind:

1. The bar for structural bond-positive factors to turn is high. Continuity of policy thought with some additional constraints on action may not be enough to change this.
2. Current bond valuations are attractive both from the standpoint of expected inflation as well as versus the policy rate.
3. We will know more on intent and execution in the budget ahead. Meanwhile, the balance of short-term positive factors should allow for that waiting time