India Forward — 19 September 2024
India’s growing capital market: Promising first steps to internationalization
The inclusion of Indian government bonds in major emerging market indexes is a step toward internationalization, but the share of government debt in foreign ownership is likely to only change gradually.
By Geeta Chugh , Angus Lam, Brian Lawson, Jose Perez-Goropze, and Aria Wahal
Highlights
Indian government bonds have attracted sizable foreign portfolio inflows, in absolute terms, since the 2023 announcement of India’s inclusion in major emerging market indexes. Net inflows are set to continue as India’s index weight increases in the JP Morgan Government Bond Index-Emerging Markets and the country is added to Bloomberg’s Emerging Market Local Currency Government Index. However, the share of government debt in foreign ownership is modest and likely to only change gradually.
Indian equity capital markets are also expected to remain active by regional standards, with a substantial planned forward calendar. International demand for Indian equities will be assisted by attractive growth prospects and an improving regulatory environment.
The projected expansion of foreign ownership of Indian government bonds is likely to free up bank lending capacity and institutional investment flows for other purposes, although banks and domestic institutions will continue to provide the bulk of state funding.
India’s inclusion in global bond indexes will encourage sizable foreign inflows to government debt and the country’s primary equity market is outperforming regional peers, with a substantial forward calendar. However, the transformation of India’s capital markets is likely to be gradual and require additional policy adjustments.
Indian debt dynamics change as its IPO market outperforms
India was added to JP Morgan’s reference index for global government bonds on June 28, 2024, marking the beginning of a transformation for India’s domestic debt market. India’s weight in the index started at 1% and will rise 1 percentage point monthly until it reaches 10% by March 2025. The index currently tracks US$234 billion of assets. India will also join the equivalent Bloomberg index in 2025 and is under discussion for inclusion in the FTSE Emerging Markets Government Bond Index.
As forecast in Look Forward: India’s Moment, fund flows to India have increased substantially because of this inclusion, with total net bond purchases by foreign portfolio investors estimated at about US$2 billion between June 28 and July 16 and at US$11.5 billion since the announcement of India’s admission to JP Morgan’s reference index.
The greater foreign focus on Indian debt markets has also modestly benefited the country’s corporate bond market. Securities and Exchange Board of India and National Securities Depository Ltd. data showed net foreign inflows of 80 billion rupees, or US$963 million, to Indian corporate debt from the start of 2024 to the end of May, after six consecutive years of net foreign outflows.
Since its green bond debut in January 2023 with an 80 billion rupee, or US$1 billion, two-tranche issuance of five- and 10-year debt, India has conducted several green debt sales, with proceeds dedicated to environmental projects and issuance extending to 30-year maturities in a 200 billion rupee green bond calendar for fiscal 2024–25. However, issue sizes have been moderate, with the bulk of these sales being purchased by domestic institutions. While India’s green bond program was welcomed conceptually by international environmental, social and governance-dedicated funds, the relatively modest scale of individual issues and their domestically targeted nature have so far restricted foreign participation. On April 5, 2024, the Reserve Bank of India granted foreign investors access to Indian green bonds. However, unless India expands its ESG focus — for example, through state development of, or funding for, renewable energy projects, permitting far larger and more liquid issuance in foreign-eligible securities — green bond sales are unlikely to substantially accelerate foreign inflows.
India’s primary equity market is also outperforming regional peers. According to London Stock Exchange Group data, Indian IPOs raised about US$4 billion in the first half of 2024, over double the volume in the same period of 2023, with a sizable pending calendar. Multiple transactions have been heavily oversubscribed, largely by domestic institutional and strategic investors.
Foreign ownership share growth in Indian government debt likely gradual
Increased foreign investment in India’s public sector debt will ease the reliance on domestic funding sources, with this likely to reduce the crowding out of the private sector and sizably increase the capital available for the country’s corporate bond market. In Look Forward: India’s Moment, S&P Global concluded that wider index inclusion could increase foreign participation in India’s government bond market to 10% from 0.9% in 2023, and that this would enable funds available for corporate debt issuers in India to almost triple relative to nominal GDP by 2030.
As mentioned, portfolio inflows to India have increased significantly since the announcement of its addition to JP Morgan’s reference index. However, due to local entities such as banks increasing their holdings — bankheld shares rose 1 percentage point for total central government bonds and 5 percentage points for Treasury bills between March 2023 and March 2024 — the foreign participation share in Indian debt has remained stable.
The further development of India’s debt capital market will require government action to improve market access and settlement procedures, also likely ushering in greater foreign participation in domestic markets alongside the increased scrutiny and potential volatility that would come with it. S&P Global’s base case, after adjusting initial estimates, is that foreign participation in government debt will gradually increase and help lower the existing crowding out effect in domestic debt markets.
Regulatory relaxation important in determining primary equity market growth
India’s primary equity market has been strong in 2024, with a sizable and expanding forward IPO calendar. Driven by regulatory improvements and strong economic growth that has outpaced other large Asian markets such as mainland China, Indonesia and Malaysia, India’s primary equity market has gained significant traction this year. It boasts the highest number of IPOs in Asia, ahead of mainland China, Hong Kong, Japan and Indonesia. Regulatory reforms, including easing ownership restrictions and streamlining foreign investment procedures, have facilitated increased foreign investment.
Likewise, the streamlined know-your-customer requirements of the Securities and Exchange Board of India and the introduction of the single-window clearance system for foreign portfolio investors have reduced entry barriers.
Since relaxing limits on foreign direct investment in the retail, civil aviation, construction, space and insurance sectors, the government is looking to ease foreign ownership limits for banking and defense, which would further enhance India’s appeal as a foreign direct investment and IPO destination.
Domestic banks to reduce government debt holdings gradually, rely on wholesale funding to expand credit
Between March 2023 and March 2024, domestic bank holdings of central government bonds increased 14%, outstripping growth of 11% in the stock of central government bonds. Holdings of central and local government securities since 2023 continues to account for 26% of total banking sector assets.
The expansion in bank holdings could be a tactical investment decision reflecting expectations of monetary easing, providing scope for future trading gains. Public sector banks hold a much larger proportion of government securities than their private sector peers, reflecting historical asset quality weakness and weak capitalization.
Going forward, banks’ role in financing government debt may gradually decline as foreign investor participation in government debt rises and corporate credit demand picks up. All banks are required to maintain an at least 18% statutory liquidity ratio in government securities, which effectively funds government debt. In the long run, a higher proportion of foreign funding in government securities may pave the way for statutory liquidity ratio reductions, reducing the role of banks in government financing. Recent growth has not been at the expense of expanded lending to the real economy, which grew 16% in the year to March 2024 — a faster growth rate than for bank holdings of government debt. Overall balance sheet expansion by banks reflects recent improvements in the sector’s capital position — including the impacts of past capital injections in state-run banks — and in asset quality metrics, boosting sector capacity for new lending.
In the future, banks’ ability to finance private sector investment could be constrained by their ability to tap domestic savings. As economic conditions improve, investors are likely to enjoy more options, such as mutual funds, equity investments and real estate, for their savings. The development of alternative investment options already contributed to a two-decade high loan-to-deposit ratio of 80% for Indian banks in December 2023. S&P Global expects this trend to constrain loan growth for many banks, with year-over-year credit growth forecast to decline to 14% in fiscal 2024–25, from about 16% in fiscal 2023–24.
Indian banks have typically relied on deposits as their main source of funding, but the structural reallocation of savings to other instruments is likely to encourage them to place greater reliance on wholesale domestic and international debt. This would occupy some of the room created by increased foreign holdings of government debt, thus increasing the available domestic funds for the corporate and banking sectors. Wholesale borrowings are likely to increase the banking sector’s cost of funding. As a result, we forecast net interest margin to fall 20 basis points to 3% in fiscal 2025–26, implying a reduction of between 10 bps and 15 bps in the return on average assets.
Favorable growth prospects attract foreign direct and portfolio investment
Although India’s growth prospects are reliant on further government liberalization, the country is well placed to perform strongly within Asia. By fiscal 2030–31, India is poised to become the world’s third-largest contributor to global growth, according to S&P Global Market Intelligence. This will boost India’s attraction to foreign investors and encourage them to reallocate prior equity investments from slower-growing markets
However, the borrowing needs of India’s government are unlikely to decline, with the country primed to continue expanding expenditure on infrastructure investment. Public sector capital expenditure is on track to reach about 3.4% of GDP in fiscal 2024–25, almost 4.5 times the level in 2012–22, in absolute terms. Large-scale investment in areas such as renewable energy and technology, including semiconductors, is likely to encourage further foreign capital participation, both directly and through equity investments. If successfully implemented, this public investment should support India’s longer-term economic growth outlook and contribute to fiscal consolidation.
Expanded foreign demand for government debt should lower yields. Additionally, strong economic growth would be a positive indicator for credit risk within the corporate sector. As foreign investment flows into government debt, freeing up capital resources for deployment elsewhere, corporate issuers are likely to enjoy lower borrowing costs and tighter debt margins. This will benefit larger, higher-rated companies and banks. Alongside this, declining wholesale funding costs should help banks continue growing their credit provision to households and smaller businesses.
Conclusion
India’s debt and equity capital markets have benefited from the country’s strong economic growth prospects. Specifically for debt capital markets, India’s inclusion in the JP Morgan Government Bond Index-Emerging Markets in June 2024 and the country’s planned addition to Bloomberg’s Emerging Market Local Currency Government Index in January 2025 will progressively increase foreign investment in Indian government debt.
The higher demand for government debt is likely to lead to lower costs of funding for India’s government and banks, reducing subsequent lending from banks to the broader economy.
This article was authored by a cross-section of representatives from S&P Global and in certain circumstances external guest authors. The views expressed are those of the authors and do not necessarily reflect the views or positions of any entities they represent and are not necessarily reflected in the products and services those entities offer. This research is a publication of S&P Global and does not comment on current or future credit ratings or credit rating methodologies.
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