Recent reports convey that foreign direct investors in India are issuing rupee-denominated bonds in international markets to hedge their rupee exposures. The investment in India creates a long position in the rupee "" and this cannot be hedged in the Indian market efficiently, even if the regulators allow it. The reason is the absence of a long-term forward market, and the relative illiquidity even at the shorter end. By issuing rupee-denominated debt in markets abroad the investor is creating a short position in the rupee which gives an effective hedge against the long position created by the investment. The bonds are rupee-denominated and carry coupons that reflect the rupee interest rates in the Indian market. While, thus, the debt is rupee-denominated all payments of principal and interest are made by the issuer in dollars equal to the rupees due at the spot rate ruling on the date of payment: the subscriber also pays for them in dollars at the spot rate ruling on the date of issue.
Since the bonds are issued by, and sold to, non-resident entities and investors one could as well call them Euro-rupee bonds. It is believed that the major buyers are NRIs, but institutional investors may also find these bonds attractive "" for example, FII investors intending to come in the Indian bond market. The bet they are taking is that the rupee would not depreciate to the extent of the differential between yields on dollar and rupee bonds of comparable credit quality. They could as well make the same play by buying the Euro-rupee bonds "" but one does not know if the secondary market in such bonds in liquid enough to attract the institutional investor. To that extent, the bond funds coming into India would be less. We can, of course, do very little about the Euro-rupee bond market "" we have no jurisdiction or control over financial contracts entered into by non-residents with each other, even if they are denominated in rupees as all settlements are
in equivalent dollars. Another financial market in rupees being exported to London?
Reports also convey that there is an active over-the-counter market in Indian equity index forwards, which are regularly traded in Singapore, Hong Kong and London. In a way, such forward contracts are a cheap way to speculate on Indian equity prices. The player who expects a rise in the index beyond the forward quotation would be a buyer of the index under the forward contract; the seller has the opposite view. On maturity, the contract will be cancelled and, depending on the actual index on the maturity of the contract, the difference compared to the forward rate will be paid by the buyer to the seller "" or vice versa. NSE has been ready to introduce an index futures contract for some time now. If the regulatory approvals take too long, one might wake up one day to find such a contract already introduced on one of the financial futures exchanges abroad.
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Be that as it may, if there is a rupee-denominated, dollar settlement bond market abroad, it is high time that we create a dollar-denominated, rupee settlement bond market in India. The idea is not mine "" Sudhir Mulji mooted it in an article in this paper quite some time back, and it has no foreign exchange implications. The concept involves Indian corporates issuing foreign currency-denominated bonds to residents who will buy them paying rupees at the ruling spot rate. The coupon will obviously reflect ruling dollar interest rates. The payout of interest and principal by the issuer of the bond will also be in rupees at the exchange rate ruling at the time the payment is due. The issuer will get lower interest rate money but carries the exchange fluctuation risk, just as if he had raised an external commercial borrowing or made or foreign currency bond issue. To be sure, although such a dollar-denominated, rupee settlement contract has no implications in terms of outflows of foreign exchange, one is not quite
sure whether it will attract any provision of Fera. To my mind, no, but I am no lawyer. Again, the fiscal treatment of losses by the issuer on redemption would need examination.
The concept is not a straight bet on interest differentials versus exchange variation. Cons-ider a company like Hindustan Copper whose prices in the domestic market are governed by the landed cost of imported copper. While it has no transaction exposure to exchange rates for its domestic sales, it clearly has an economic exposure (World Money, September 29, 1996) to the dollar:rupee exchange rate. So do other companies that produce goods which are like commodities (rather than products), and which are under OGL. Current exchange control regulations do not permit economic exposures to be hedged in the forward market. A dollar denominated bond would be a good hedge.
Inflation-indexed bonds
One major innovation in the last budget was the introduction of inflation indexed government bonds. As I had argued in this column (On July 15, 1996), this could help reduce the governments borrowing costs by eliminating any inflation uncertainty premium structured in the broadly market-determined coupon rates. The advantage to the investor of course is that the bonds eliminate the risk that inflation may rise, thereby reducing the value of his investment in conventional, non-indexed bonds. Marketed properly, the bond may prove attractive to individual investors and pension funds as a hedge against inflation. Another advantage would be that the redemption premium on the principal amount would presumably be treated as a capital gain for tax purposes. Nor is the issuer, in this case the government, running a major risk should inflation rise : in that case, so would the government revenues in nominal rupees and allow the debt to be serviced without creating undue strains on fiscal resources. Indeed, there is a
case for even corporates to consider issuing inflation-indexed bonds, the rationale being parallel.
Dollar debt is, in a way, an inflation-indexed bond as, over time, the exchange rate will broadly be governed by inflation differentials.