India: 6 Insights for Emerging Markets Debt Investors

India is top of mind for many emerging markets debt investors, and below I provide some insights from a recent research trip, where I met with companies, politicians, and policy advisors throughout Mumbai and New Delhi to dive deep into current investment risks and opportunities.

1. Drivers and Constraints in India’s Economic Growth Outlook

India’s economy is projected to grow by about 7% this fiscal year, a number that is increasingly viewed as India’s new level of potential growth. Rural consumption should rebound after a strong harvest. However, concerns about weaknesses in labor-intensive sectors and insufficient job creation linger.

One thing India has going for it is that consumption, which accounts for about 65% of India’s GDP, is being bolstered by rising wealth and income gains from capital markets. Private capital expenditure is also rising, particularly in non-tradeable goods, while some tradeable goods face competition from Chinese imports.

Another contributor to India’s economic growth is that infrastructure development, especially in road transports and railways, has seen rapid expansion, driven by strong financing. However, India’s energy transition remains slow and is at an early stage, with solar, wind, and hydro investments lagging. Low margins in solar projects have deterred some investors, further slowing progress.

The China +1 strategy, under which multinational corporations have sought to diversify their manufacturing and sourcing operations by adding at least one additional country outside China, has benefited India’s economy, especially in electronics manufacturing. But India’s potential gains from this strategy were impacted by the country’s infrastructure gaps, a complex regulatory environment, labor market rigidity, and competition from other countries.

2. Inflation To Likely Stay Within Target Range

The Reserve Bank of India (RBI) prioritizes headline inflation over core inflation because it encompasses the prices of all goods and services, including volatile items such as food and energy, making it more politically relevant and easily understood by the public. The RBI aims to keep headline inflation within a flexible target range of 4%, plus or minus 2%.

Currently, the real interest rate—calculated by subtracting the inflation rate from the nominal policy rate—is about 2.5%, which is higher than India’s estimated neutral real rate of 1.5%. This suggests that monetary policy is relatively tight, potentially constraining economic growth. If signs of economic weakness emerge, such as underperformance in economic activity or rising unemployment, the RBI may respond by cutting the policy rate. This would lower real interest rates, making borrowing more affordable, stimulating investment and consumption, and supporting economic growth.

While the RBI’s approach to inflation targeting provides some flexibility, other factors also complicate monetary policy decisions. Tracking labor market data in India remains a challenge, complicating policy adjustments based on labor conditions.

India’s inflation-targeting framework is set for review in March 2025. While new external members will have joined the Monetary Policy Committee (MPC) in October, significant policy changes are unlikely.

India’s economy is projected to grow by about 7% this fiscal year, a number that is increasingly viewed as India’s new potential growth target.

3. Fiscal Challenges Amid Political Pressures

In recent years, lower fiscal deficits and higher tax revenues have created room for increased capital expenditure in India. The government is pursuing fiscal consolidation, with deficit targets of 4.9% for 2024 and 4.5% for 2025. However, achieving the 2025 target may prove challenging, as India has already made significant progress in curbing current expenditures. And after the recent elections, political shifts have raised the likelihood of increased spending on subsidies, transfers, and social security.

Political dynamics also pose a risk to India’s economic outlook. The Bharatiya Janata Party (BJP) lost seats in the general elections, partly because of its fiscally conservative budget, while the opposition Congress party gained ground through social media outreach and negative campaigning. With several state elections in the next six months, the BJP may face pressure to regain support by announcing new welfare policies, such as the Unified Pension Scheme (UPS), which aims to provide financial stability to India’s government retirees.

4. Indian Rupee Stability: A Market-Approved Approach

Some foreign-exchange traders have criticized the Indian rupee's (INR) stability, and there are some suggestions that current balance-of-payments (BOP) dynamics indicate the rupee should appreciate.

However, the RBI does not focus on the real effective exchange rate (REER) and dismisses concerns of excessive intervention in currency markets.

Most market participants have been satisfied with the rupee’s stability, and the RBI continues to accumulate reserves, which currently cover about 12 months of imports. We view this reserve buildup as a positive step toward ensuring macroeconomic stability, especially if portfolio flows reverse.

We view this reserve buildup as a positive step toward ensuring macroeconomic stability, especially if portfolio flows reverse.

5. Balancing Risks and Opportunities in India’s Financial Markets

An emerging concern in India is the increase of futures and options trading among retail investors. More than 90% of retail traders have lost money, with losses as much as INR1.8 lakh crore over three years.

Signs of overvaluation are also appearing in equity markets. Some retail investors have even taken loans against property to invest in the stock market. It’s not surprising, then, that there is a significant supply-demand mismatch in India's financial markets, with local demand for financial securities estimated at about 1.5 times that of supply.

High cash positions held by mutual funds offer some buffer against these risks, and large initial public offerings (IPOs) may help reduce the supply-demand gap.

Nevertheless, regulatory actions have intensified in response to these challenges, with restrictions on equity derivatives trading, stricter stress testing requirements for mutual funds, and closer monitoring of leverage. Regulators are, however, also considering easing registration rules for well-established foreign investors, such as sovereign wealth funds and mutual funds.

As India economic formalization progresses, more financial transactions are expected to move through formal channels. But the current supply-demand imbalance remains a concern. Long-term continued foreign investment will be necessary to fund the country’s growth.

More than 90% of retail futures and options traders have lost money, with losses estimated at INR 500 billion this fiscal year.

6. Upskilling Workers A Critical Reform

Improving the overall business climate remains essential for sustained growth in India, as the goods and services tax (GST), demonetization, and COVID-19 have severely impacted micro and small enterprises that once played a key role in worker training.

Reforming labor-related regulations is also essential for boosting job creation. India’s education system lags global standards and there is a pressing need for more training programs to create quality jobs. Much of India’s labor force work informally and in low productive sectors. Labor displacement is also a long-term concern. 

Overall, job creation is a key challenge, and reforms to expand formal sector employment will be critical to ease labor-market pressures.

In Summary

Macroeconomic stability has been the foundation of India’s growth, and maintaining this stability will continue to be a priority for the country's long-term success. This includes implementing prudent fiscal policies, ensuring effective monetary policy, and fostering an environment conducive to investment and innovation.

In addition, we believe that addressing structural issues, such as labor market reforms and infrastructure development, will be essential for sustaining growth.

By combining macroeconomic stability with addressing structural issues, India can attract potential foreign investment, create jobs, and enhance overall economic resilience, positioning itself as a leading player in the global economy.

Johnny Chen, CFA, is a portfolio manager on William Blair’s emerging markets debt team.