India Takes Center Stage

In the last several years, fixed-income opportunities expanded for foreign investors looking to gain exposure to India. While the Indian sovereign does not issue bonds in dollars, Indian corporates do, and they offer exposure to attractive sectors. Separately, foreign investors are increasing exposure to India’s rupee-denominated government debt on the back of the June 2024 inclusion into JP Morgan’s most widely followed emerging market local bond index.

> As the world’s 5th largest economy and most populous democracy, India is increasingly important for global investors and policymakers.

> Since 2000, GDP growth has averaged 6.2% in the context of a unique development model. Unlike many fast-growing emerging market (EM) economies, which relied on manufacturing as their engines of development (China, Japan, South Korea, etc.), India’s service sector is its growth engine. Equally impressive, in the last decade, India maintained its healthy growth rates in a context of relative macro stability.

> Under the leadership of Prime Minister Narendra Modi, who became India’s Prime Minister in 2014, India’s government has logged essential gains in its quest to unlock the economy’s growth potential. Measures have ranged from structural reform legislation to the introduction of a broad digital and physical infrastructure agenda.

> With the physical infrastructure buildout, the government hopes to energize the country’s comparatively limited industrial sector. Geopolitical factors, specifically the diversification of global supply chains, may give India an advantage as it seeks to compete in the high-end manufactured goods industry.

> Prime Minister Modi pledged that India will be a developed country by 2047. To come close to achieving this, additional reforms are necessary, particularly when it comes to land and labor.

> In the last several years, fixed-income opportunities expanded for foreign investors looking to gain exposure to India. While the Indian sovereign does not issue bonds in dollars, Indian corporates do, and they offer exposure to attractive sectors. Separately, foreign investors are increasing exposure to India’s rupee-denominated government debt on the back of the June 2024 inclusion into JP Morgan’s most widely followed emerging market local bond index.

> In early 2024, we traveled to India to gain insights about its political and social dynamics. We spent time in Mumbai and Delhi and traveled to rural areas to better understand the nuances of India’s socio-political backdrop. The concentration of power in the executive and the nationalistic Hindu-centric government’s handling of minority rights are sources of risk.

Since 2000, India’s economy has been one of the fastest growing in the world. The country moved from the world’s 13th largest economy in 2000 to the 5th largest in 2023 (in nominal terms). In purchasing power terms, the best approximation of transaction volume in the economy, India is the 3rd largest economy globally. In 2000, India’s economy contributed a modest 4% to global GDP growth. By 2023, its growth accounted for 18% of global growth (chart).

In the last decade, sound macroeconomic policy fostered stability. A narrowing current account deficit (CAD) facilitated much of that stability. The improving deficit is mainly attributable to two factors: a surge in service exports linked to global capability centers (GCCs)1, and diminished dependence on imported oil. A smaller CAD and consistent financial account inflows helped India’s external balance sheet improve materially. The Reserve Bank of India (RBI) has accumulated a war chest of international reserves totaling over $685 billion, more than double the figure at the end of 2012. This allows India to buffer itself from external volatility and avoid the type of pressure the economy experienced during the 2013 “Taper Tantrum.”

In 2016, India was one of the last EMs to transition its monetary policy framework to an inflation-targeting (IT) regime, with a 4% target and a 2% tolerance band. Relative to the consumer price indices of other countries, India’s inflation benchmark is more heavily skewed toward food prices, which can be quite volatile and constitute 46% of the index. To account for this, the RBI targets inflation over an average of three quarters. Since adopting the IT regime, monetary policy outcomes have been positive, as inflation has remained largely contained around targeted levels.

India’s Unique Path

A former Chief Economic Advisor to the Indian government, Arvind Subramanian, described India aptly when he referred to the country’s “precocious development model.” According to Subramanian’s work, there are two aspects to this: political and economic. On the political side, India is unique in that it has been democratic since independence. In Subramanian’s words, “India is a complete outlier in having sustained democracy at very low levels of income, low levels of literacy, with deep social fissures, and with a highly agrarian economy.”2 The second unique feature of India’s growth model is that the country moved directly from being an agrarian economy to one dominated by services.

In contrast, for most fast-growing EM economies, the path to economic development was relatively uniform: they moved from agriculture to manufacturing, then shifted toward services once reaching a certain level of income per capita. This is encapsulated in the Asian model of development seen in the second half of the 20th century. India’s development path is unique, so its policy configuration must differ from other prominent development examples, especially in Asia.
HSBC has produced a large body of research that classifies India’s economy into two halves: “New India” (technology- driven, led by the service sector and advanced manufacturing) and “Old India” (dominated by low-tech/small manufacturing and agriculture).3 “New India’s” service sector has logged impressive gains externally and domestically. Externally, India’s service exports increased from 6% of GDP in 2005 to over 9.5% of GDP today. Most recently, the rise of GCCs turbocharged services exports. Domestically, advances in digital infrastructure have energized the service sector, paving the way for tech startups.4  

So Much Done…

Under the leadership of Prime Minister Modi’s Bharatiya Janata Party (BJP), the government has tried to loosen constraints on India’s growth. We divide the reform agenda into three parts: structural reform legislation, digitalization, and physical infrastructure. Broadly speaking, these should benefit India’s total factor productivity (TFP), which, in the words of noted economic analyst Ed Yardeni, is like “fairy dust sprinkled on the economy.” The contribution of TFP to India’s growth has increased in recent years and could, with the right policy mix, improve further (chart).

Structural Reform: Starting with structural reforms, we highlight two: the Goods and Services Tax (GST) and the Insolvency and Bankruptcy Code (IBC). These reforms addressed substantial inefficiencies in the Indian economy.5 The GST is a single tax system that applies uniformly across states, eliminating tax arbitrage and creating the conditions for India to have a more unified market. It also had other positive knock-on effects by reducing corruption at state borders and significantly increasing the fiscal tax take, bringing entire supply chains into the formal market. Turning to the IBC, under the old bankruptcy regime, winding down failed businesses was highly cumbersome, fragmented, and frequently impossible. The IBC laid the groundwork for the streamlined resolution of insolvencies. While local commentary suggests that unwinding businesses is still slow-moving post-IBC, it is a massive improvement and necessary for facilitating foreign and domestic investment.6

Digitalization: In the last fifteen years, India’s digital drive has expanded financial inclusion. Digital Public Infrastructure (DPI) is an essential ingredient in the country’s growth mix. As the Bank of International Settlements (BIS) notes, deepening the financial system is invariably linked to economic development.7 DPI consists of three layers – identity, payments, and data exchange.8 Combined, these are known as the “India Stack.” Its base is a biometric ID called Aadhaar, which, starting in 2009, gave all Indians access to a biometric-linked 12-digit identity number. By 2022, nearly 100% of adults were registered.9 Add-ons to this system allow the government to send money to Aadhaar-linked bank accounts, streamlining government transfers, and preventing leakages.10 This is extremely important. In our conversations with political analysts, they noted that this innovation completely transformed the Indian welfare system by ensuring that benefits reached the intended targets. It also allowed the government to abolish duplicative social programs.

Turning to the payments layer, the best-known platform is the Unified Payments Interface (UPI), introduced in 2016. Anyone with a digital wallet can participate in UPI, which speaks to a broader point about financial inclusion: UPI was “intended to bring payment efficiencies to low-value transactions.”11 Coinciding with our experience in India, UPI has a very high penetration rate, even among small shops (chart). The story does not end here, with innovations incorporating the data exchange layer of the India Stack. This includes Digilocker (2015), which allows all Aadhaar holders to have accounts in the Cloud that store authentic government documents, and, more recently, an account aggregator (2021) that provides infrastructure for securely sharing financial data.

Physical Infrastructure: Modi’s government has overseen a massive increase in physical infrastructure, primarily financed by the public sector. Per India’s 2024 Economic Survey, between 2019 and 2023, the central and state governments accounted for nearly 80% of total infrastructure investment. In other words, private sector investment was comparatively low at just over 20% of the total.12 In addition, government outlays have increased significantly in the last four years, with budgeted capital expenditures doubling from 1.7% of GDP in fiscal year 2020/21 to 3.4% of GDP in fiscal year 2024/25 (chart).13 Roughly half of the total spending is on roads and railways.

The results of India’s infrastructure buildout are visible. For example, between 2014 and 2023, the national highway network increased by 60%. Capital expenditure on railways increased by 77% in the last five years, leading to a buildout in rail networks, such as medium-distance express trains.14 Furthermore, two freight corridors are near completion in a country where passenger trains have historically been prioritized (and freight trains have had to wait to pass).15 Per The Economist, the government’s stated goal is to reduce the cost of logistics in India to 8% of GDP by 2030 from 14% of GDP as of 2023.16

This infrastructure drive overlaps with the Indian government’s effort to lay the foundation for a more dynamic manufacturing sector. This falls under the umbrella of a government-led campaign known as “Make in India.” Targeting more dynamic manufacturing makes sense intuitively, with economists from the RBI advocating for India to widen its manufacturing base to meet the demand of a large domestic market.17 Historically, manufacturing is a sector that can generate larger-scale employment opportunities, if firms can reach sufficient size. Achieving this scale is one area where India has fallen short.18 Of course, infrastructure is a piece of the puzzle but not a turnkey solution to fortifying the sector. Other hurdles include weaker “Doing Business” indicators along with labor and land reform (discussed below).

One factor that works in India’s favor is a growing diversification of global supply chains. In what is known as the “China +1” strategy, businesses are increasingly moving away from an overreliance on China. As companies seek to diversify their supply chains, the question is how much India stands to benefit vis-à-vis its emerging market peers. A constellation of an improving investment environment, better infrastructure, a growing high-skilled workforce, and government subsidies (known as “production- linked incentives”) have set the stage for India’s high-end manufacturing to increase its competitiveness. This has been something that the Indian government has marketed aggressively to multinationals. There have been some successes, with companies such as Apple and Samsung establishing phone factories in India, as well as progress in attracting “green-sector” manufacturing, such as electric vehicles and solar power.

… And So Much to Do

In a 2022 speech commemorating India’s independence, Prime Minister Modi promised that India will reach “developed nation” status by 2047 (Viksit Bharat, in Hindi). Since then, this has become the administration’s rallying cry.19 There is no hard and fast rule of what it takes to be a developed country, but using the World Bank’s income threshold for “high income countries,” the RBI calculates that GDP per capita would have to increase from $2,500 today to nearly $22,000 over the next 25 years. This implies a real compounded annual growth rate of 7.6%, significantly above the 6.2% registered since 2000. This type of growth, while not unprecedented, has typically only been seen in countries that are starting from a lower GDP per capita base. For example, South Korea’s starting point in 1965 was $1,274 per capita (in constant 2015 dollars) and China’s in 1982 was $480 (in constant 2015 dollars).20

Higher growth would need to come from some combination of labor, capital, and productivity (TFP). Many economists put India’s potential growth rate on the order of 6.5%, below the RBI’s identified level needed to reach “developed nation” status by 2047. To achieve this higher growth rate, the RBI suggests that productivity and capital must be a focus. From our perspective, this kind of transformation requires a continuation and acceleration of the reform agenda that India has seen over the last decade.

Certain structural reforms are widely understood to be fundamental for unlocking India’s medium-term growth potential. For example, one of India’s shortfalls is its labor market. Labor force participation is low, with the employment rate between 55% and 60% of the working- age population, including a materially lower participation rate among women.21 In turn, labor informality is high, and informal workers have faced several shocks in recent years, the most recent being the pandemic.

This is partially a labor supply issue, with educational quality lagging. As former RBI Governor Raghuram Rajan noted, India “firstly needs to make the workforce more employable…”22 While high-level education for a small segment of the population is world-class (in tech, for example), overall, educational outcomes in India are poor. The Economist notes that this is particularly true in the country’s North.23 On the labor demand side of the equation, jobs, especially high-quality jobs, are not created quickly enough to accommodate India’s growing working- age population. Rigid labor laws are a material hurdle; if it is hard to fire workers, companies will not hire them in the first place.24

Another outstanding issue is land reform. Land rights are not easily transferred, and land titling is challenging. This makes it difficult for economic agents to undertake private investment, particularly large-scale foreign direct investment projects. Our conversations in the country directly addressed this issue. While labor and land reforms sound straightforward in theory, in practice, there is overlapping jurisdiction between the states and federal government. In other words, such reforms cannot be mandated from above; states must also have an appetite for reform. Separately, policymakers must contend with powerful vested interests. For example, one of Prime Minister Modi’s first legislative defeats was linked to the administration’s attempt to do land reform in 2015, which sparked massive protests.

Environmental, Social, and Governance Considerations

When we invest in countries, a piece of the puzzle is understanding the environmental, social, and governance backdrop. These factors can present both risks and opportunities. On environmental policy, India has moved quickly to adopt renewable power, with capacity doubling in the last five years;25 non-fossil fuel generation capacity now accounts for 44% of the total.26 Public health, energy self- sufficiency, and import cost considerations motivated the government’s green energy development policy, which has presented investment opportunities (detailed below). On social indicators, extreme poverty and infant mortality have shown steady declines in recent decades. Notwithstanding, progress is uneven, with people in rural areas, particularly women, still struggling with caste discrimination and limited employment opportunities. We observed this while traveling with a non-governmental organization in rural India.

From a governance perspective, Prime Minister Modi remains popular in the context of solid growth and innovations like digitalization, which have positively impacted the lives of many. However, there are concerns on two fronts: a) Prime Minister Modi’s concentration of power, and b) the BJP’s Hindu-centric stance and their handling of Muslim rights.

These issues present potential political risks for investors. For example, ahead of elections in Q2 2024, the BJP ran a polarizing parliamentary campaign emphasizing Hindu nationalism. The results severely disappointed government expectations, with the BJP unable to secure a majority in parliament and losing support compared to the last election. This forced the BJP to seek coalition partners to govern and was widely viewed by local analysts as a check on Prime Minister Modi’s power. It also signaled that there were limits to the effectiveness of using religious nationalism as a political strategy.

Investment Opportunities in Indian Fixed Income

The economic backdrop in India makes for a compelling investment opportunity. India’s stock market has attracted international attention as one of the top returning markets over the past ten years. However, we focus on an up-and- coming corner of the Indian market — public fixed income. An essential part of the story for fixed income investors is India’s stable, investment-grade credit rating. India achieved investment grade status from Moody’s in 2004 (Baa3), S&P in 2007 (BBB-) and Fitch in 2006 (BBB-). The ratings have hardly changed over this time, though S&P moved to a positive outlook in May 2024.

Foreign investors can access both sovereign and corporate debt markets in India. One interesting market characteristic is that India does not issue foreign currency-denominated sovereign bonds; of the 15 largest developing countries, India is the only one with this distinction. Instead, the local currency debt market is large and liquid because the Indian government has funded itself in rupees for decades. India has also not sought out foreign capital for government financing; foreign holdings of Indian government bonds are low at about 2.5% of debt outstanding (June 2024).

There have been new developments, in particular JP Morgan’s decision to add India’s government bonds to its mainstream EM local bond index, the GBI-EM Global Diversified. Indian bonds began phasing into the index in June 2024 and will increase to the maximum 10% index weight by April 2025.

As alluded to, India has not gone out of its way to attract foreigners into its local bond market. In fact, the government has long had strict (and low) quotas that limit non-resident ownership. Rather than change its policy on existing bonds, in 2020, the RBI launched a special series of government bonds, the Fully Accessible Route (FAR), which do not have restrictions on foreign ownership; such bonds now represent approximately 40% of India’s government bond market. These are the bonds that are being added to JP Morgan’s index.

Estimates from various sell-side banks suggest that India may receive $20-40 billion of inflows because of index inclusion; JP Morgan estimates that foreign ownership would roughly double to 4.4% of the outstanding market, still low compared to peers. Bond investors are likely to be attracted to India not only for the country’s solid economic fundamentals but also for the relatively high yields. The blended yield-to- maturity on India’s local debt is roughly 7% (as of August 2024); over the past ten years, the yield has averaged about 1% higher than the yield of the GBI-EM Global Diversified. Gaining exposure to the Indian rupee is a notable component of investing in the local market. While the currency risk can be hedged for a cost, investors have been comfortable owning bonds unhedged. The rupee has featured very low volatility compared to its peers (chart), aided by sound monetary policy management and a healthy external position, including an elevated level of international reserves.

In terms of corporate issuers, we focus on investing in the large Indian conglomerates which are involved in many different business segments. This is because smaller businesses in India borrow predominantly from local banks. In the case of the conglomerates and their subsidiaries, the parent companies are some of the largest issuers in India due to the

size of their borrowing needs. As a result, they borrow not only from local banks and local capital markets but also from international capital markets. Most of these companies are domestically focused, so they hedge their USD borrowing back to rupees. These larger Indian companies are typically owned by a “promoter” group, which tend to be wealthy families who started their businesses decades ago. While these promoter groups have sold shares in their companies, most publicly listed in India, they often retain controlling stakes and veto rights.

While the USD corporate bond market has grown significantly since 2004, it remains relatively small compared to the size of the Indian economy ($3.6 trillion), with only about $60 billion in debt outstanding. Financials, Utilities, Energy, and Infrastructure are the key sectors represented by India in the widely tracked JP Morgan Emerging Market Corporate Bond Index (CEMBI). As India continues to grow and diversify its economy, we expect a broader set of sectors to emerge. International demand for Indian corporate bonds is high, particularly since investors in Asia have fewer opportunities following shrinking issuance from Chinese companies in recent years. This has resulted in a strong technical backdrop for Indian USD corporates.

Payden’s Approach to India

At Payden & Rygel, we analyze all EM countries using a ‘scorecard’ approach, whereby we score key fundamental variables – including various economic, environmental, social and governance factors (ESG) – on a forward-looking basis.

We have tended to score India’s outlook favorably in recent years, reflecting the positive structural trends described in this piece. Our constructive fundamental view has been the impetus behind our allocations to India’s fixed income and (at times) currency market, well before index inclusion.

Within the corporate market, the areas we have been most constructive on are renewable energy companies and non- bank financials. In the renewable sector, beyond government support, costs are falling, and energy demand continues to grow. Moreover, companies in the renewable sector are typically owned by large institutional investors, who can provide additional equity capital and/or liquidity if needed. We like select non-bank financials because of the strength of India’s regulatory regime and the high capital ratios that these institutions maintain (25-30% equity capital). These companies have high growth potential and generate significant profitability.

In the local market, we find rupee currency exposure attractive, given a high carry-to-volatility ratio and supportive macroeconomic policy. Payden has also been scaling up rupee-denominated bond holdings. Beyond pure government bonds, one part of the market where we see value is rupee-denominated supranational bonds. These instruments trade at a similar yield level to the government curve but enjoy higher credit ratings than the sovereign, given their institutional backing. Examples would be debt issued by the International Bank for Reconstruction and Development (World Bank).

India provides interesting opportunities from several angles, ranging from the economic to the geopolitical. We are comfortable with the macroeconomic framework and see government policy supporting the private sector in the medium term. In turn, growth should remain strong in the next several years. It is noteworthy that the question is not whether growth will slow, but how much growth could accelerate if everything comes together, including a continuation of the reform agenda. On the geopolitical front, India’s increasing importance is already evident in company decisions to diversify supply chains to hedge against potential China risk, as well as deeper strategic partnerships with countries like Saudi Arabia and the UAE. Given the trends in place, it is easy to imagine that India’s prominence on the global stage will continue to rise.

Voetnoten

1 GCCs are offshore centers used by multinational companies that have evolved from back-office operations to technologically sophisticated entities in areas ranging from artificial intelligence to chip design.

2 Subramanian, Of Counsel. Pg. 8

3 Bhandari and Chaudhary, “India’s Digital Date.”

4 Bhandari, Chaudhary, and Mehrishi, “India’s Big Leap In Services.”

5 This list is not exhaustive with other important reforms such as the real estate reform (RERA) coming into effect.

6 Garrido and Rosha, “Strengthening Private Debt Resolution Frameworks.”

7 D’Silva et al., “The Design of Digital Financial Infrastructure.”

8 Garrido and Rosha, “Strengthening Private Debt Resolution Frameworks.”

9 Per the Unique Identification Authority of India

10 Parkin, Reed, and Singh, “The India Stack.”

11 D’Silva et al., “The Design of Digital Financial Infrastructure.”

12 Indian Ministry of Finance, “Economic Survey.” Pg. 445

13 Chinoy, Jain, and Sood, “India’s Budget.”

14 Indian Ministry of Finance, “Economic Survey.” Pg. 413

15 The Economist, “India Is Getting an Eye-Wateringly Big Transport Upgrade.”

16 Ibid.

17 Behera et al., “India @ 100.”

18 Bhandari and Chaudhary, “India’s Digital Date.” Pg.19

19 Bhatia and Roy, “Modi Is $20 Trillion Short on His Grand Plans for India’s Economy.”

20 Behera et al., “India @ 100.” pg 90-91

21 Chinoy, Jain, and Sood, “Indian Economic Outlook.” May 2024

22 Roy and Strumpf, “India Making a Mistake Believing ‘hype’ about Growth, Says Raghuram Rajan.”

23 The Economist, “Narendra Modi’s Ultimate Test—Educating 265m Pupils.”

24 Chinoy, Conversation.

25 The Economist, “The Energy Transition Could Make India Even More Unequal.”

26 Reuters. “Non-fossil fuels account for 44% of India’s power generation capacity – power minister.”

References

Alonso, Cristian, and Margaux MacDonald. “Advancing India’s Structural Transformation and Catch-up to the Technology Frontier.” IMF, Working Paper No. 2024/138, July 9, 2024, 33.

Behera, Harendra, V. Dhanya, Kunal Priyadarshi, and Sapna Goel. “India @ 100.” RBI Bulletin. Reserve Bank of India, July 2023.

Bhandari, Pranjul, and Aayushi Chaudhary. “India’s Digital Date.” HSBC Global Research. HSBC, May 2023.

Bhatia, Ruchi, and Anup Roy. “Modi Is $20 Trillion Short on His Grand Plans for India’s Economy.” Bloomberg, April 28, 2024. https://www.bloomberg.com/news/articles/2024-04-28/narendra-modi-is-20-trillion-short-on- his-grand-plans-for-india-s-economy.

Chinoy, Sajjid. Conversation, 2024.

Chinoy, Sajjid, Toshi Jain, and Divyanit Sood. “Indian Economic Outlook.” JP Morgan, May 2024.

———. “India’s Budget: Of Prudence and Plumbing.” Global Fixed Income Research Survey. JP Morgan, July 24, 2024.

D’Silva, Derryl, Zuzana Filkova, Frank Packer, and Siddharth Tiwari. “The Design of Digital Financial Infrastructure: Lessons from India.” BIS No 106 (December 15, 2019): 39.

Garrido, José M., and Anjum Rosha. “Strengthening Private Debt Resolution Frameworks.” In India’s Financial System, 292. International Monetary Fund, 2023. https://www.elibrary. imf.org/display/book/9798400223525/CH010.xml.

Indian Ministry of Finance. “Infrastructure: Lifting Potential Growth.” Economic Survey. Ministry of Finance, July 2024.

Parkin, Benjamin, John Reed, and Jyotsna Singh. “The India Stack: Opening the Digital Marketplace to the Masses.” Financial Times, April 20, 2023. https://www.ft.com/content/ cf75a136-c6c7-49d0-8c1c-89e046b8a170.

Roy, Anup, and Dan Strumpf. “India Making a Mistake Believing ‘hype’ about Growth, Says Raghuram Rajan.” Business Standard, March 26, 2024. https://www.business-standard. com/economy/news/india-making-mistake-believing-hype- about-growth-says-raghuram-rajan-124032600389_1.html.

Subramanian, Arvind. Of Counsel. Haryana, India: Penguin Random House, 2018.

The Economist. “India Is Getting an Eye-Wateringly Big Transport Upgrade.” The Economist, March 13, 2023. https:// www.economist.com/asia/2023/03/13/india-is-getting-an- eye-wateringly-big-transport-upgrade.

———. “Narendra Modi’s Ultimate Test—Educating 265m Pupils.” The Economist, June 28, 2023. https://www. economist.com/asia/2023/06/28/narendra-modis-ultimate- test-educating-265m-pupils.

———. “The Energy Transition Could Make India Even More Unequal.” The Economist, January 4, 2024. https://www. economist.com/asia/2024/01/04/the-energy-transition-could- make-india-even-more-unequal?