10 years a slave: it’s time to set the Indian bond markets free

As the world’s largest democracy trundles its way to the polling booths, foreign investors wait with bated breath for a government that is going to promote greater access to the Indian debt market, transparency, a well-defined regulatory system and (most of all, perhaps) enforceability of rights when investments go pear shaped. Indeed, liberalisation of the debt market will provide much-needed funding to restart the stalled growth engine. Economic growth and the current coalition government’s failure to deliver the reforms necessary to get India back to 10%-plus growth rates will figure large in the ultimate results of these elections. Don’t let the rhetoric (religious or otherwise) fool you. People want better lives. Period.

Along with liberalisation, enforceability of rights has been a big bugbear for foreigner investors. The experience over the past five years or so (particularly in the foreign currency convertible market) has left a feeling that senior overseas bondholders sit behind even equity holders when defaults occur. Historically, when push has come to shove, local courts and regulators only care about domestic investors. As one central bank official was heard saying in private last year, “Why should we care about foreign investors losing money? If they choose to invest in badly operated local companies, it’s their lookout.” Foreigners were by and large seen as speculators and not investors and their money shunned until the currency fell apart last year. Many non-resident Indian readers have been approached over the past 12 months to invest in FCNR (foreign currency non-resident) deposits in an attempt to woo foreign funds back to the market. Too little, too late.

You see, Indian bureaucrats have two burning obsessions that underpin their prejudice against opening up the domestic debt market to outsiders. Firstly, what they call “round robining” or the belief that Indian promoters use the issuance of foreign bonds to route undeclared overseas funds back into their onshore company accounts. Clamping down wholesale on the bond market to block folks who want to circumvent the tax system is a very crude and heavy-handed way to deal with the problem. Unfortunately, innocent companies get inadvertently caught in the crossfire, unable to tap overseas markets for cheaper funding because of a few bad eggs in the community. Secondly, foreign currency issuance is oft blamed for putting undue pressure on the rupee. This attitude is self denial at best. A country’s currency is a barometer for the nation’s financial health. Fix the economy and the currency will track accordingly. Needless quantum of foreign exchange reserves are endlessly used up to shore up the currency. I liken it to attempting to eradicate malaria by shooting down mosquitoes one at a time. Surely, you’re likely to be more successful in your endeavour if you clean the swamp where the mosquitoes are breeding, instead?

So how much investment is required to get India’s stalled growth engine back on track? Well, let’s consider infrastructure spending requirements — a key area where the coalition government has failed to deliver. In the 12th Five-Year Plan (2012-2017), the government has projected an investment requirement of $1.5 trillion or 6% of GDP. According to experts, this has to be at least 10% of GDP to get back to growth rates of 8-9%. This is a mind-blowing figure by any country’s standards, let alone a country that we all know is struggling for funding on so many fronts. As domestic growth slows down (which brings with it lower savings, worsening current account deficit, falling rupee), how is the funding gap to be bridged?

As I explained to overseas investors at the recently held India Inc-organised investment conclave in London, expanding the bond market internationally is one way in which the government and local corporates can tap cheaper funding. For risk-averse investors, bonds are the perfect instrument to gain exposure to the unfolding India story. For issuers (Indian PSUs and corporates) it’s a way to reduce borrowing rates. By going overseas, issuers can borrow at single digit rates (5-7%) in foreign currency as opposed to mid to high teens (13-17%) in rupees. For companies that have a significant international element to their business model, borrowing in foreign currency is especially scalable. However, despite the generally good quality of issuers and a growing economy, the market remains a fledgling and offers minimal opportunities for foreign investors. Indeed, the availability of Indian bond market data remains thin and is indicative of the nascent nature of the market.

Size matters: Rough estimates show that the accessible Indian bond market is roughly $200-400 billion in size (accurate data is difficult to come by). The US bond market in comparison weighs in at a whopping $35 trillion. The scope of growth for the Indian market (across all financing vehicles) is huge (see: How they stack up).

How they stack up

Despite solid demand and a rising consumer base, the depth of Indian markets lags mature ones and languishes at the lower end of Asian emerging markets

Accessibility remains difficult: To access the Indian bond market as it stands, foreign investors have a choice of Eurobonds (including convertible bonds), domestic bonds and managed bond funds (JPM India Active Bond Fund). The Eurobond (or non-rupee) market is dominated by bank and financial institution issuers. Within the Eurobond segment is a sub-segment of convertible bonds issues mainly consisting of mid-cap issuers.

Foreign investors remain marginal players in the domestic market due to central bank imposed market restrictions. Currently, to invest in the domestic market you either have to be an FII (foreign institutional investor) or, if you’re an NRI, you have to possess an overseas citizen of India (OCI) card, PAN card and cross many other hurdles before you can inject money into bonds. On top of that, foreigners are restricted to holding an aggregate total of $30 billion in government debt and are also restricted in how much corporate debt they can hold. However, there is increasing momentum behind the idea of liberalising the bond market and allowing it to grow.

Sebi published a paper last year condemning the current restrictions as too complicated and a hindrance to implementing economic policy. According to the report, the restrictions run counter to India’s growth needs. Opening up the market will enable the country to tap foreign money much needed to fuel growth. For investors, it will create a larger and more liquid market. Additionally, including Indian bonds in global bond indices would also attract investment from foreign pension funds and insurance companies.

A costly affiar

Long-term borrowing rates are set to go higher in the coming year

Enforceability, the experience with convertibles: The Indian foreign currency convertible bond (FCCB) market grew at a breathtaking pace from 2004 through 2009, going from near zero to approximately $25 billion in size, but has stalled and gone into shrinkage mode since. The collapse of Lehman and the retrenchment of global debt and equity markets was a watershed moment for India issuers. Until then, most issuers believed their stock was going to the moon and, hence, that they would ultimately avoid having to repay these loans (as convertibles are usually converted into shares if the underlying shares perform well). Unfortunately, many mid-cap stocks did not recover from their 2008 lows and widespread defaults hit the market. In many cases, there was also the discovery of gross corporate malfeasance.

In the aftermath, foreign investors have found it almost impossible to enforce their rights, blaming the archaic and bureaucratic local court system and overly complicated rules around default events per Sebi and the RBI. Moreover, the frequent “moving of goal posts” by the authorities, without any warning or apparent commercial logic, makes the experience even more frustrating. Many FIIs now avoid Indian bonds as an investment option unless the issuers are well-known blue chips or the issuance is linked to the monetisation of government holdings in PSUs.

Study in contrast

Indian sovereign yields remain at the top end of the spectrum

Indian bond returns reflect macro risk and liquidity concerns: domestic, non-agency Indian bonds tend to yield in the 9-11% range. Indian Eurobonds (non-rupee debt) trade tighter in the 1.5-5% range. The table, Study in contrast, shows Indian yields in the context of the overall Asian market. As one can see, Indian bond yields are at the top end of the range, reflecting growth concerns. There’s also an element of illiquidity premium in there, as per the discussion above.

Market access remains highly restricted. Liberalisation is key and the voices calling for reform are growing both from within the walls as well as outside. Relying on the growing middle class to single-handedly consume India to the top just isn’t a plausible strategy anymore. India needs cheap foreign money to boost growth.

However, foreign investors have already been hurt by the Indian government’s failure to deliver on economic reforms, infrastructure build out and job creation. This has lead to a stalling of growth rates on more than one occasion. The fallout from this? Rising inflation and a plummeting currency. To compound issues, the relatively diminutive size of the bond market means that Indian paper doesn’t exactly trade like water. When markets get dislocated (a la 2008), getting out of bonds in a falling market can be extremely painful.

Moreover, corporate governance and promoter misbehaviour is the ever-present elephant in the room. Until India deals with problems of corruption and corporate malfeasance, the country will never function efficiently as an economy.

As this article goes to press, the Indian media is pointing to a likely landslide victory for Narendra Modi and the BJP. Regardless of the results of these elections, we pray and hope for an administration that abandons the protectionist stance that has prevailed over the last 10 years. It’s the only way the Indian juggernaut can get back on track.