After a muted first half of the year, global investors turned net buyers of Indian stocks in July. Since then net foreign investment in Indian equities has reached 657 billion rupees (US$8.3 billion), compared with net outflows of 2.17 trillion rupees (approximately US$27.5 billion) between January and June.

The renewed interest in the country is partly a reaction to fears of recession that are gripping many other large economies and the hope that India, the world’s fifth largest economy, may be left relatively unscathed.

The revival in foreign inflows has helped India’s benchmark stock index to outperform its Asian peers. India’s benchmark Sensex index rose 14.5% in the three months to Sept 14. By contrast, Japan’s Nikkei 225 grew 4.5%, the Shanghai stock exchange rose 0.3% and Hong Kong’s Hang Seng Composite index fell 10.5% during this period.

Nitin Bhasin, head of research at Ambit Capital, said while foreign investors are back in the fray, domestic investors have also stepped up their game. By Ambit’s estimates, net inflows from domestic investors totalled US$30.8 billion between January and August.

The turnaround of the Indian bourses – in mid-June the benchmark index was down 17% from an all time high in October 2021 – seems ahead of the country’s economic realities. While India’s gross domestic product grew 13.5% year on year in the April-June quarter, it lagged the central bank’s estimates of 16.2%. Retail inflation topped 7% in August, higher than the 6.71% in July, exceeding the Indian central bank’s target of 6% for eight months in a row.

Still, in comparison to India, GDP in the US shrank 0.6% in the April-June quarter. In China, the economy grew by a meager 0.4%, stymied by the government’s zero-Covid policy that led to protracted lockdowns and threatened exports.

In comparison, India is more of an importer. According to government data, India’s imports surged more than 37% to US$61.9 billion in August, driven by an increase in procurement of crude oil, vegetable oil and chemicals. With exports rising 1.62% to US$33.92 billion, India’s current account deficit is set to increase and further weaken the rupee, which has fallen about 7.5% against the US dollar this year.

“If the US goes into recession, then revenues of information technology companies in India will be hit, and so will overall export growth,” said Ambit’s Bhasin. “But remember, India is not as heavily reliant on exports as China.”

A sharp fall in crude oil prices has added to the optimism over India, which is the world’s third largest oil importer and meets about three-quarters of its domestic needs through imports.

Besides, while Indian stocks command a premium over its emerging market peers, prices have come off their peak. They were trading at about 18 times the expected one year forward earnings in July, when foreign investors turned net buyers, below the 10-year average of 19.5.

Ashhish Vaidya, head of treasury at DBS Bank, said a string of policy reforms rolled out by the Indian government – including incentives to spur local manufacturing of electronic components and electric vehicles – will enable the country to “add value to the global supply chain”. Coupled with a global push to develop manufacturing hubs outside China and a general aversion to invest in China and Russia, that augurs well for India.

“The way India’s macro (indicators) are stacking up because of the current account deficit and trade deficit obviously doesn’t look exciting,” said Vaidya. “That said, let’s also look at the structural reforms happening in India.”

Global capital is also likely to start chasing India’s sovereign bonds after reports that JP Morgan is considering inclusion of a large chunk of India’s US$1 trillion of rupee-denominated bonds in its flagship GBI-EM global diversified index, which also features Asian economies such as China, Indonesia, Malaysia and Thailand.

The bank’s consultation with potential investors revolves around 20 so-called “fully accessible route” bonds, which allow foreign institutional investment without any restriction. Investment bank Morgan Stanley says India has issued FAR bonds to the tune of US$263 billion, and expects US$360 billion of the bonds to be available by the second half of 2023.

It believes that the inclusion will draw at least US$30 billion into India by the financial year ending March 2024, reducing the cost of borrowing for the government. An inclusion in global indices can increase foreign holdings in India’s government bonds from 1.2% at present to 9% by 2030, Morgan Stanley estimates.

Foreign investors already appear to have stepped up purchases of FAR bonds in anticipation of their inclusion in the GBI-EM index. According to Reuters, they bought FAR bonds worth 66 billion rupees in the six weeks to Sept 9, while selling securities in other categories worth 18 billion rupees.

International interest in Indian debt would help the government, whose resources have been stretched by stimulus packages in the aftermath of Covid-19. The fiscal deficit rose from 4.59% of GDP in fiscal 2020 to 9.3% the year after. Higher tax revenues helped to cut the deficit to 6.71% in fiscal 2022.

“The fact that Indian bonds don’t feature in global indices has led to a muted demand despite them offering better returns than many other countries,” said Sujan Hajra, chief economist and executive director at financial services firm Anand Rathi.

While discussions on India’s inclusion into global indices have been going on for a few years, the Indian government and bankers could not agree on whether to allow offshore settlement of the bonds. The government contended that offshore settlement would disadvantage domestic investors, who pay the state a capital gains tax on selling the bonds.

Madan Sabnavis, chief economist at Bank of Baroda, cautioned that inclusion in global indices may render Indian bonds more vulnerable to volatility in global markets, particularly when yields are rising. Yields on government bonds have risen above 7% from about 5.5% in January last year.

But the positives range from a boost to India’s foreign exchange reserves to a lower cost of borrowing for corporate borrowers. “A surge in demand for government paper will lead to a drop in yields, and automatically yields for corporate bonds will also come down,” said Sabnavis.