Informist, Monday, Oct 25, 2021
By Vaibhav Chakraborty
NEW DELHI – The inclusion of Indian securities in global bond indices could lead to incremental inflows of $25 bln-$30 bln in the initial months itself, says Badrinivas N.C., Citi's South Asia managing director and country treasurer and head - markets and security services.
"The planned steps towards getting India sovereign bonds included in the global bond indices could be the big game changer that alters the demand-supply gap in the future, bringing in large flows from global investors," Badrinivas tells Informist in an interview.
Once international clearing of Indian bonds begins, many global investors will start investing in India on the assumption that their inclusion into global indices will follow within a reasonable timeframe, he says.
Till such a time, the Reserve Bank of India may need to periodically intervene in the bond market, especially since the peak of systemic liquidity and the low point of the rate cycle are most likely behind us, Badrinivas adds.
Currently, India is seen very favourably by international investors due to a host of factors, such as an impending global bond index inclusion, the 'China plus one' strategy of global companies, the government’s economic boost with its production-linked incentive scheme, and a relatively high rate of vaccination against COVID-19.
Badrinivas says the domestic bond markets offer enough opportunities to take advantage of the steepness in various parts of the yield curve.
"If you hold the view that the pace of rate hikes will be slow and the terminal rate in the next cycle is likely to be lower than the past, there are enough opportunities to take advantage of the steepness in various parts of the curve.
"Timing is the key and one would have to be nimble in assessing the curve play," he says.
Following are edited excerpts from the interview:
Q. When 2021 started, the catchphrase in the markets was reflation trade. But markets have found it hard to stick to a secular theme. In your view, what is 2022 going to be all about - on rates as well as forex?
A. Policy normalisation and the new normal could be the key themes for 2022 as the world emerges from the pandemic. As economies open up further, the pressure on central banks to normalise policies will be high. The pace of normalisation will be complicated by inflation worries and uncertainties around the potential growth amidst a new normal. The inflation debate between transitory and entrenched could take a few more months to be resolved. The bigger uncertainty will come from understanding the new normal of the post-pandemic world – be it in labour market dynamics, permanency in supply-side costs, consumer behavioural shifts, if any, especially in emerging markets, and tolerance for high public debt, to name a few.
Fitting these new themes into the traditional growth-inflation trade-off will be the biggest challenge for markets as well as policymakers, going into 2022.
Currencies where central banks normalise faster will be favoured compared to those where central banks are seen as behind the curve. Geopolitics could also play an increasing role in determining the destination for global flows and investments and, eventually, influencing markets.
Q. What are the interest rate expectations the Indian swap curve currently reflects? How do you think the RBI will proceed on tightening from here?
A. The swap curve is pricing in some hikes in 2022 itself, reflecting expectations of the unwinding of the ultra-low policy rates as the economy normalises. The markets have tended to be ahead of the curve compared to the RBI's guidance, partly because of global factors, but also because of its reading of the primacy of the inflation target of the Monetary Policy Committee.
I do think there has been a subtle but important shift in the current MPC's view of the inflation targeting mandate versus the earlier MPC, which had put more emphasis on achieving the 4% inflation target.
The current MPC has interpreted the policy mandate a bit more broadly by acknowledging the 'flexible' part of its flexible inflation targeting mandate. This has led to them being less obsessed with a number, but looking at a broad range of indicators, including drivers of headline inflation, capacity utilisation in the economy, the pace of credit formation, etcetera.
The extraordinary situation of a pandemic causes policymakers to be cautious in their forward assessments - one does not want to be making definitive predictions on such an unknown phenomenon – while markets tend to trade based on probabilities. Once the risk seems to recede, the markets tend to price in quick normalisation, but it's no guarantee that the policy path will follow suit.
As we move into 2022 and with the pandemic easing, the normalisation of extraordinary measures including a move higher in the reverse repo rate are likely, but repo rate changes will take longer. The MPC will chart a glide path towards the medium-term inflation target of 4% by 2023-24 (Apr-Mar) and is unlikely to shock the system through preemptive rate hikes. Sustainability of the growth recovery will be an important variable influencing the pace of rate hikes in this cycle.
Q. More than half the government's borrowing programme is now behind us. Does the going get any easier from here?
A. The fiscal situation is much better than what we started the year with, aided by tax collections being much higher than the conservative Budget estimates. Further, bank credit continues to be in mid-single digits, sustaining steady demand from banks for government securities. However, as credit picks up, demand-supply dynamics are likely to be challenged.
Public debt issuance across central, state and public sector undertaking units in aggregate is still quite large, and the demand gap needs support from RBI, till we find new investors. The planned steps towards getting Indian sovereign bonds included in global bond indices could be the big game changer that alters the demand-supply gap in the future, bringing in large flows from global investors. But till then, interventions from RBI may be required periodically, especially since peak system liquidity and the low point of the rate cycle are most likely behind us.
Q. Has the outlook for the Indian rupee changed materially over the last one month, in light of the widening current account deficit and the global market volatility?
A. As the economy opens up, widening of the current account deficit is expected. Surging oil and other commodity prices will weigh on the trade deficit numbers. However, capital flows are likely to be quite strong, and we continue to expect a reasonably significant balance of payment surplus into next year, which will keep the rupee as one of the better performing currencies.
India is currently seen very favourably by international investors and multiple factors are at play in furthering this narrative. Some of these include the 'China plus one' strategy of global companies, the government's push under the production linked incentive scheme, high levels of digitisation of the Indian economy, relatively high vaccination rates in the country, and China's strong policy curbs in some new-age sectors.
Bond index inclusion is another possible generator of large inflows. So, while our range for the rupee against the US dollar has shifted to 74-76 rupees, our outlook continues to be favourable for the rupee. Risks stem mainly from a further surge in crude prices and any sharp fall in the global growth outlook.
Q. The next challenge for bonds will be policy normalisation. To what extent will the steepness of the curve provide a cushion against the gradual policy tightening expected from the RBI?
A. The steepness of the curve does provide some cushion. However, it also needs to be looked along with the large bond supply. Also, the adequacy of the current steepness will have to be judged based on what is one's view of the terminal rates in the next hiking cycle. Broadly, policy normalisation will result in the flattening of the curve, and we feel the five-year part of the curve offers a better risk-reward ratio on the basis of the steepness.
The borrowing calendar for the second half is less in the up to five-year segment, while the proportion of duration papers is higher. In the absence of a sustained Government Securities Acquisition Programme, the 1- and 5-year spread is likely to flatten, while the 5- to 10-year spread could further steepen from current levels.
Q. What is your trade recommendation on India rates, amid the current environment of uncertainty on growth, inflation, and global market volatility?
A. If you hold the view that the pace of rate hikes will be slow and the terminal rates in the next cycle are likely to be lower than the past, there are enough opportunities to take advantage of the steepness in various parts of the curve.
Timing is the key and one would have to be nimble in assessing the curve play. Presently, we feel the steepness in the one-year overnight indexed swap rates and 4- to 5-year part of the bond curve are quite rich, spreads could continue to widen in the 5-year part of the OIS curve as well as back-end duration bonds.
As I said before, global bond index inclusion would be a game changer for Indian bonds and one should look to play for a big fall in term premia when you get visibility of the event.
Q. What is the order of flows you envisage because of India's bond index inclusion? What is the earliest possible timeline for flows to start in earnest?
A. Getting Indian government bonds listed for international central securities and depository clearing is the key milestone towards the index inclusion. I believe most tax issues and other rules of engagement for residents are likely to be clarified, which will be an enabler for the international listing.
Once we get to that stage, many global investors will start investing in India on the assumption that index inclusion will follow within a reasonable timeframe. Sentiment will also turn favourable and various other investor segments, including domestic players and existing registered foreign portfolio investors, are likely to expand their investments and duration ahead of the actual index inclusion.
So, there could be reasonable flows commencing from the time of global listing. The actual size of flows on index inclusion will be a function of the index weights that would be accorded to India. Based on our calculations, we believe the weights could be large enough to get at least $25 bln-$30 bln of inflows in the initial months from index tracking funds. End
US$1 = 75.02 rupees
Edited by Avishek Dutta
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