Dear Mr Modi, It's time to convert

Anyone hoping for a controversial call here to India’s new prime minister to switch his religious preferences is going to be sorely disappointed. However, (potentially not as spicy, I’ll admit) there’s plenty going on in the finance and investment arena at the moment for readers to focus on and be excited about. With the Sensex crossing the 25,000 mark for the first time ever recently, there’s certainly a great deal of positivity out there as a result of the change in government. Investors are hoping that the new regime will deliver on both economic and market reforms, much needed to re-invigorate the country’s flagging growth rate. Indeed, India stands on the verge of a new era and it is imperative that the new government be on point with its financial strategy. As Narendra Damodardas Modi frees himself from all the ceremonial demands of the last few weeks and turns his attention to the actual job at hand, one of the primary issues on his agenda will be public funding. There is no doubt that the exiting party will, in true time-honoured fashion, barely leave two brass farthings (or perhaps more aptly, two paise) in the coffers to rub together. Mr Modi will need to create some liquidity. Pronto.

Mr Modi’s options? Higher taxation? We all know the tax system is very effective in India (ahem). Reportedly, only 2-3% of Indians actually pay any tax at all. So, a bit of an uphill climb there, I think. His second (and probably more realistic) option is to raise money in the markets. He can either sell bonds to the public via the central bank or he  can sell assets to investors. I believe that the new PM should consider selling partial stakes in public sector undertakings (PSUs) in which the government has a 51% or greater equity stake. Now, he could sell the equity outright, but I believe that by using convertible or exchangeable bonds, the government can a) sell these stakes at a premium to current market value; b) issue bonds at lower interest rates to domestic Indian lending charges; and c) retain the full size of their stakes until/if the bonds are converted (depending on accounting standards applied).

Global precedent

Exchangeable helps governments, corporates charge a premium to stock prices

So, what is an exchangeable bond? Exchangeable bond or, simply, exchangeables are a type of convertible bond. In a regular, plain vanilla convertible issue, the borrower issues debt that is convertible into the company’s own shares. By embedding an equity option in the bond, issuers can access cheaper financing than would otherwise be available via straight bond issuance. Where an exchangeable differs from the norm is that the issuer and the underlying company are different. This has been a popular structure with foreign multinationals (especially with Germans, who have used exchangeables to divest cross holdings in other group or non-group companies). Foreign governments have also used exchangeables to raise money by divesting their holdings in the public sector. On the flip side of the coin, investors favour the structure as the credit risk on the issuer is bifurcated from the risk on the underlying stock. That is, the underlying stock may perform poorly but as long as the issuer’s credit remains solid, bondholders will be comfortable with regards to retrieving their initial investment.

The India scope

The government has interests in over 250 separate companies ranging from the travel sector to energy and infrastructure. Not surprisingly, for a country on such a steep growth trajectory, the energy sector dominates public sector interests. Irrespective of this, these are all sectors to which investors would dearly like to gain exposure. The largest PSU is the Indian Oil Corporation (IOC), with a market capitalisation of around $15 billion. The Indian government currently owns 68.57% of the company. The government could consider reducing its stake to 51% by selling 17.57% of its shares — worth approximately $2.6 billion — to the public. However, it could achieve a significantly better valuation by offloading the shares by issuing a Government of India exchangeable into IOC shares. Issuing an exchangeable instead of selling plain shares enables the issuer, in this case the government, to charge a premium to the price on the Sensex. Why so? Since the government is guaranteeing an end value for the bond at maturity, hence protecting the investor from any equity downside (ceteris paribus), it gets to charge investors a premium for this protection. I estimate that this premium can be anywhere between 25% and 40%. Through an exchangeable, the government can achieve a value for its 17.57% of $3.25 billion at the lowest end of the scale — over $500 million in excess of current equity market value. Moreover, an exchangeable/convertible note issued by the government would no doubt prove extremely popular with global investors.

 Domestic vs Foreign: all about favourable pricing

Foreign investors remain marginal players in the domestic market due to central bank-imposed market restrictions. Yet, it’s foreigners who can provide cheap funding. The SEBI published a paper last year condemning the current restrictions as running counter to India’s growth needs. Opening up the market will enable India to tap foreign money needed to fuel growth. 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 firms that have a significant international element to their business model, borrowing in foreign currency is especially scalable.

Drop it like it’s hot

The government has enough scope for divestment

The recently-concluded elections and the landslide endorsement of the BJP is a clear message from the electorate: they want an economically resurgent India. They want the nation’s growth rate to return to the high single digits at the very least. India needs to invest heavily in the areas of infrastructure (where the government needs to plough in trillions of dollars), welfare, housing and job creation (not to mention manage the fiscal deficit). If you consider infrastructure spending requirements alone (a key area where the coalition government has failed to deliver), the government had projected an investment requirement of USD 1.5 trillion or 6% of GDP in its 12th Five Year Plan to 2017. According to experts, this needs to be at least 10% of GDP to get back to growth rates of 8-9% (source: IBEF, Jan 2013). For that, India will need liquidity, and plenty of it. Moreover, I believe foreign currency exchangeable bonds offer the perfect route to maximising the selling value of government assets and simultaneously accessing cheaper rates of funding. The new government would be well advised to take a closer look at this financing option. Hopefully, I’m preaching to the already converted.