The report of the Working Group on Development of Corporate Bond Market in India (H R Khan report) makes several recommendations on different aspects of the bond market in India. Most of the steps recommended have been tried before, in various forms. However, it makes two new recommendations. One, that foreign portfolio investors (FPI) must be allowed to invest in unlisted bonds issued by Indian entities and not only infrastructure companies, as is currently the case. Two, it recommends that FPIs to be allowed to invest in pass-through certificates issued by securitisation vehicles. These two reforms were largely overdue. However, even these two new recommendations do not address the three fundamental problems that shroud foreign investment in the Indian debt market.
First, the ban on FPIs in short-term debt securities, which the Reserve Bank of India (RBI) imposed in February 2015, must be lifted. The H R Khan report states that a majority of the corporate bond issuances are in the two-five years tenor. This is not too different from other similarly placed economies. As we demonstrated in a previous article in this paper, in Korea, close to 50 per cent of the total outstanding bond issuances belonged to the one- to three-year maturity bracket. The corresponding figures for Indonesia and Thailand were 57 per cent and 40 per cent respectively. These economies, with which India is competing for foreign investment, do not have a minimum maturity period embargo for foreign investors.
Attempts to increase FPI investment in the bond market while trying to prohibit FPI investment in the under-three-year maturity profile is, therefore, counterproductive. More importantly, there is no systemic risk-related concern in connection with FPI participation in short-term rupee-denominated bonds, as the issuer is not exposed to exchange risk.
Second, the RBI must get its act together in cleaning up the regulatory framework governing rupee-denominated borrowings from non-residents. Currently, foreign investment in rupee-denominated debt is governed by three separate sets of quasi-legislative instruments. One, Schedule 5 of the Foreign Exchange Management (Transfer or Issue of Securities by Non-Residents) Regulations, 2000 (popularly known as FEMA 20), which lists the asset classes FPIs may invest in. Two, the Master Directions on External Commercial Borrowings and Trade Credits, which apply to rupee-denominated debt raised by Indian borrowers (January 2016). Three, the RBI circular on offshore bonds (September 2015), which governs the issuance of rupee-denominated offshore bonds by Indian entities. These three quasi-legislative instruments substantively govern the same economic transaction, namely, rupee-borrowing by an Indian issuer from a non-resident. However, they specify different terms and conditions depending on whether the borrowing is in the form of onshore bonds, offshore bonds or rupee-denominated loans.
For instance, if an Indian company wants to borrow a rupee-denominated loan equivalent to $50 million from a non-resident lender, the minimum maturity period for the loan is three years and the minimum maturity period for a rupee loan exceeding $50 million is five years. On the other hand, when an FPI invests in rupee-denominated bonds issued by an Indian company, the minimum maturity period is three years, notwithstanding the amount of the investment. Similarly, there is an enumerated list of people of entities, who may borrow a rupee-denominated loan from a non-resident, and an enumerated list of lenders who may advance a rupee-denominated loan to an Indian resident. However, there is no such enumerated list of borrowers, which may issue or subscribers, who may subscribe to rupee-denominated bonds abroad, despite the nature of the liability undertaken by the Indian company being substantially the same in both sets of transactions.
The combined debt limit for all foreign investment in rupee-denominated bonds, both onshore and offshore, is capped at Rs 2.44 lakh crore. Consequently, the per-entity limit for issuance of offshore rupee bonds is also expressed in rupees. However, when the borrowing is in the form of a rupee-denominated loan, the limits are expressed on a per-entity basis in USD terms. These are but some instances of inconsistencies in the regulatory framework governing rupee-denominated debt.
The legal framework for foreign investment in the rupee-denominated debt market must treat similar economic transactions similarly. Where an Indian entity borrows in rupees from a non-resident, the same rules must apply, whether the borrowing is in the form of a loan or bonds. Currently, our ECB framework lacks this level of maturity and continues to focus on a sectoral approach, by extending benefits to different sectors depending on which sector is stressed at any given point of time. The framework for capital controls in debt should instead focus on addressing the systemic risk arising from unhedged currency mismatches on the balance sheets of borrowers.
Third, an attempt to increase foreign investment in local currency debt flows must be complemented with the development of the currency derivatives market that will allow FPIs to seamlessly hedge their currency risk. Until June 2014, FPIs were not allowed to hedge their currency risk on Indian exchanges. Even when they were allowed at this late stage, they were only allowed to freely take positions up to $10 million. An FPI taking a position beyond this limit is required to demonstrate an underlying exposure in Indian assets. This adds to the cost and complexity of investing in the Indian markets. While a recent RBI press release has promised to ease the rules of participation by FPIs in currency futures, the detailed guidelines are expected to be issued in November 2016.
The two recommendations on foreign investment in the Indian debt market are belated but welcome. The regulator must complement them with cleaning up the complex regulatory edifice that is vulnerable to frequent ad-hoc changes. Unless this is done, such small big bangs, no matter how noble in intent, will not have their intended effect.
Bhargavi Zaveri is a research associate at the Indira Gandhi Institute of Development Research.
Radhika Pandey is a consultant at the National Institute of Public Finance and Policy
Radhika Pandey is a consultant at the National Institute of Public Finance and Policy
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