INTRODUCTION
Masala Bonds are rupee-denominated instruments issued by Indian borrowers (an Indian corporate) to financial specialists abroad. This instrument was initially conceptualized by the International Financial Corporation (IFC), the investment arm of World Bank in 2013. Masala bonds were issued by IFC and the returns put resources into Indian infrastructure. Considering positive acknowledgment of the instruments and steady request from the Indian corporate, the Reserve Bank of India (RBI) chose to enable Indian organizations to issue these instruments under the External Commercial Borrowings (ECB) Policy – Issuance of Rupee denominated securities abroad. While these instruments are secured under the ECB framework, yet dissimilar to different forms of ECB, it is subject to least limitations like end use of proceeds, list of qualified financial specialists, no cap on all in cost, estimating of bonds, and so forth. Taking sign from the RBI, Ministry of Corporate Affairs and the capital market controller – SEBI exempted masala securities from compliances like applicability of Companies (Share Capital and Debenture) Rules, 2014 and SEBI (Foreign Portfolio Investors) Regulations, 2014 respectively which generally would have defaced the attractiveness of these instruments. Masala bond is an off spring of developing peril connected to foreign currency designated ECB because of falling rupee. To counter this hazard, borrowers needed to fall back on derivate contracts yet it increased the borrowing cost. On the other hand, masala bonds are changed over in foreign currency (let’s say dollars) on the date of issuance according to the predominant exchange rate. Subsequently, the borrower is required to service debt obligations like instalment of settled loan fee and pre-agreed redemption amount in rupee. From that point, this rupee amount is changed over into equal dollars according to the common exchange rate. This implies the risk of currency fluctuation stands shifted from the borrower to lender. The elements of masala bonds can be comprehended from the following illustration. Indian Company PQR issues bonds in London carrying interest rate of 8.10% per annum. The bonds are purchased in GB Pound by investors at the current conversion rate. At the end of maturity period, let’s say 3 years, redemption amount is paid based on the assured return. However, this amount is paid to investor in INR which is to be converted into GB Pound or any other international currency. If INR has depreciated on the date of redemption, the currency risk will have to be borne by the bond investor. If Indian borrowers fail to meet their foreign debt obligations they look up to the banks for refinancing to bail them out. If banks refuse to do so, the company will go into insolvency. This means the entire chain is laden with systemic risk giving rise to sovereign risk obligation. As per CRISIL study in 2013, the total outstanding foreign currency loan of Indian companies stood at an alarming figure of USD 200 billion and most of these borrowings were unhedged. In the current year, there is an estimation of approximately USD 70 billion unhedged borrowings in dollars. Masala bonds have been designed to first, mitigate this volatile situation and secondly, to overcome the problem of original sin. original sin. However, can masala bonds provide an alternative mode of raising funds to give fillip to the stalled infrastructure projects especially, when the banking sector is crumbling under the pressure of NPAs.
COSTING FROM INVESTOR’S PERSPECTIVE
Theoretically several benefits of masala bonds can be counted, but we must understand the practical underlying challenges. The success of any debt instrument depends primarily on the investor’s perspective which is directly influenced by the cost-benefit analysis. There are several components which constitute the costing of masala bonds. The broad components are hedging cost, credit risk cost and finally the withholding tax liability. Since an investor in masala bond is exposed to currency exposure risk and considering the volatile nature of INR, it is likely that investors in masala bonds will choose to hedge their currency risk. Hedging contracts means added cost. This is done in Non-Deliverable forward (NDF) market at offshore centres like Dubai, Singapore, New York, etc. NDFs are derivative instruments where trading is done in restricted currencies like INR (India does not have full capital convertibility) which serves as the underlying asset but there is no actual delivery of the currency. The underlying asset never exchanges hand but the contract is settled by paying off the difference in exchange rates i.e., contractually agreed rate – prevailing spot rate. The final position is settled by paying in international currencies like US dollars, GB Pound or Euro. As per treasury analysts the average hedging cost at an offshore centre is approximately 6.5% annually. This means the net yield is further reduced. The hedging in NDF market is only likely to increase looking at the trend of falling INR against US dollar. While investors have been allowed to hedge their exposure in permitted derivative products with AD-I category banks in India, they prefer offshore centers to avoid regulatory control of RBI. Since NDF markets operate mostly with the objective of currency arbitrage, such activities could have an adverse impact on the Indian currency. Moreover, such offshore NDF market is beyond the jurisdiction of RBI, in other words, the impact of such offshore betting in Indian rupees cannot be regulated. If not in regular market conditions, in volatile market conditions the NDF market transactions can have an impact on the domestic spot markets. The bid offer spreads which are an inherent feature in offshore hedging contracts entered in NDF market has its influence on the currency in the domestic market. However, currency risk is not the only exposure, because an investor also needs to factor in the credit risk. The profitability of Indian companies is not improving. The investment in the manufacturing sector is on the constant decline. Banks are neck deep in litigations with the companies over loan defaults. Under these conditions, the investor in masala bonds may want to enter into credit default swap (CDS) contracts which means this will add up to the overall costing of the transaction. The recent issue of masala bonds by HDFC carried an annual yield of 8.33%. Now let’s assume this is the standard yield rate on masala bonds. This yield is subject to withholding tax of 5% under the Income Tax Act, 1961 which reduces the actual yield rate. As per bankers this adds to 40-50 basis points to the cost of bonds. Now there are two possibilities – either the investor compromise with the reduced yield considering sub-zero rates in developed nations or issuer increases the yield rate to compensate investors for the taxation component.
PECULIARITIES OF INDIAN BOND MARKET
IFC has successfully issued rupee denominated of worth Rs. 106 billion to international investors. But the success of IFC cannot guarantee positive performance of bonds issued by the Indian companies. First, IFC enjoys AAA credit rating whereas, India’s credit rating is BBB- (as per Standard & Poors and Fitch). To impress foreign investors the instruments must bear stable credit rating which means masala bonds need not be accessible to large number of medium and small scale enterprises lying down the credit curve. Even the Indian corporate with credit rating of AAA- are discounted at the international forum. Secondly, the Indian bond market is mostly dominated by government securities and financial institutions with the ratio of sovereign debt to corporate debt ratio of 2.7:1. Therefore, the depth of Indian bond market is shallow compared to other nations. Past experience of issues in dollar denominated bonds show that foreign investors usually favour bonds issued by public sector units. In this sticky situation, masala bonds would remain confined to government securities and top fifty companies. Thirdly, rupee denominated bonds faces stiff competition from country like China which has much matured bond market with its Dimsum bonds (renminbi denominated) already popular amongst the international investors.
QUANTITATIVE RESTRICTIONS AND OTHER IMPLICATIONS
The RBI has fixed the aggregate limit of foreign investment in corporate debt in rupee terms, and therefore, the maximum amount which can be borrowed by an entity in a financial year under the automatic route by issuance of these bonds will be Rs. 50 billion and not USD 750 million as given in the earlier circular dated September 29, 2015. Proposals to borrow beyond Rs. 50 billion in a financial year will require prior approval of the RBI. These restrictions can act as dampener for the borrowers. Further, RBI has tried to ensure that the proceeds from issuance of bonds come from only Financial Action Task Force compliant jurisdiction. The recent RBI circular issued in 2016 states that the issuer must obtain a list of primary holders and submit it with Indian regulatory authorities. However, the bonds are freely transferable in the secondary market and therefore, the ultimate investor will not remain static. Besides, some taxation experts are of the opinion that international depositories lack transparency and tracking the list of primary and second holders may pose practical challenge. This could be an area of concern for RBI in light of aggressive money laundering activities to introduce the tax evaded income back into the economy.
WAY FORWARD
It is extremely difficult to predict the possible consequences of an unprecedented event like demonetisation. However, if there is further depreciation of rupees, borrowing cost will increase as lenders would expect higher premium (interest rate) to cover their cost of risk hedging. Further, the investors will demand better interest rates to compensate for the currency loss. China has already witnessed this phenomenon when renminbi declined against US dollar, issuers of Dimsum bonds had to up the interest rates to lure investors. As far as the problem of original sin is concerned, it is a complex issue and expecting masala bonds as panacea to address this concern may not hold correct. There are instances from the past where developing nations like Russia, Venezuela and Argentina have defaulted in meeting obligations in domestic currency bonds. The policy makers must realize that future of rupee denominated bonds is intertwined with the fate of domestic corporate bond market. The present domestic bond market is marked with features like uncertainty, poor credit and recovery culture, information asymmetry between issuers and investors, etc. Therefore, successful implementation of the Insolvency and Bankruptcy Code, 2016 assumes critical importance. However, past experience suggest that there has been no decline in intervention by courts, which became the prime reason for failure of the SARFAESI Act. CDS contracts are quite popular in off-shore markets to hedge credit risk. The offshore CDS market is often characterized by speculative trading where players enter into contracts without even holding the instruments. Such speculation activities can certainly influence the Indian bond market and currency. However, this could be checked if the bond investors are given an option to explore the Indian CDS market which is presently underdeveloped and lacks liquidity. RBI has recently allowed banks to participate in issuance of masala bonds. This move has been welcomed by the banking industry, especially public sector banks (PSBs) who have been badly bruised by Indian borrowers, and therefore, banks are expected to explore this option aggressively. Since PSBs indirectly reflect the sovereign rating of India, investors prefer bank issues. However, they would also have to keep strict vigil over the existing shareholding of Government and its future disinvestment plans. On the taxation front, it is commendable that the Government has reduced the withholding tax liability from 20% to 5% on masala bonds and excepted the capital gain tax. The Finance Bill, 2017-18 has further provided for extension of the concessional rate of 5% withholding tax on interest payable on these bonds before July 1, 2020. However, the rate is similar to the TDS obligation applicable to foreign currency denominated bonds. If we are serious enough to promote masala bonds, withholding tax liability should be phased out to enhance the overall net return on these instruments. Besides, the Government must get over with the biasness against foreign investors and remove quantitative restrictions in the bond market.
CONCLUSION
Masala bonds can be the first meaningful step towards full capital account convertibility regime, provided our macro-economic fundamentals are sound and strong. For this we need to build a more matured onshore bond market with sufficient depth. In addition to the Indian firms, the global brands operating in India must also be encouraged to issue these instruments. This will enhance the credibility of the instruments among the foreign investors. In China, foreign entities like McDonalds and Caterpillars have issued Dimsum bonds. Besides, disputes arising in case of defaults can be swiftly settled through international arbitration without falling prey to delays of the Indian judiciary. However, Indian courts must not entertain baseless interim applications which often mars the international arbitration process. Moreover, the overall-cost effectiveness of masala bonds will be the deciding factor. In the current regime, different regulatory authorities are working in a coordinated manner striving to architect a fundamentally strong policy framework. With the emerging nations becoming the sought after investment destination and Chinese economy slowing down, India is the only shining spot in the global economy. RBI has performed far better than its counterparts whenever global economy nosedived and thereby enjoys great international reputation. This certainly goes in favour of masala bonds in boosting confidence of the investors. With these conditions in the background, we must leverage this opportunity, so masala bonds can provide the credible and elusive global status to the Indian currency.