India's feeble coalition government is taking bold steps to reform its debt market. Just four months after opening up domestic corporate debt to foreign investors, it has let them into the government bond market.
The mood is upbeat among investment banks and fixed-income analysts looking to India as their next destination. "The first preference of any foreign investor is the local risk-free paper," says Stephen Van Wilberding, chief operating officer at investment bank DSP Merrill Lynch. "It's a simple calculation of weighing the rupee risk against the coupon."
With the Indian rupee expected to depreciate annually by between 5% and 7% (annual depreciation of the rupee averaged 4.4% in the last three years), he says, the current 13% coupon on two-year to three-year Indian gilts matches returns in the favourite emerging markets in the region: Indonesia, Thailand and South Korea.
Most foreign portfolio funds invested in the Indian bourses are in equity but analysts expect around $1.5 billion to flow into Indian debt this year. Three debt funds floated by Chescor International, Credit Suisse and Schroders have already been cleared to invest $203 million. Among those waiting in the wings are Peregrine, Templeton, Morgan Stanley and Barclays.
The Indian government, in turn, is hoping for portfolio investment to help it reach the annual target for foreign investment (portfolio as well as direct investment) pegged at $10 billion. Last year foreign investment in India was a meagre $4 billion, a fraction of what China is attracting.
The Indian debt market may be among the largest in the region but it is not the most liquid. A study by consultant Price Waterhouse put it next only to the Japanese and Korean bond markets with an approximate size of Rs3,000 billion ($84.03 billion) as of January 31 1995. Government debt accounts for nearly 60% of this and is the most liquid end of the market.
Trading in debt is done mainly on the National Stock Exchange (NSE) and more recently the Bombay Stock Exchange. Average daily traded value on the NSE debt market has been rising over the last year but is still low at $69 million in January. At present Indian banks and insurance companies, the largest holders of debt, have little inducement to trade as a large chunk of their portfolio is valued at cost because regulations require only half of it to be marked to market.
The Indian government has good reasons for bond market liberalization. It is the single-largest issuer of debt with an annual borrowing programme of around Rs400 billion. Historically, the Indian government has financed its deficit by issuing paper at way below market rates to a captive market of commercial banks and insurance companies that have to invest around a quarter to a half of their funds in them. "This resulted in large monetization which in turn led to high interest rates for all other borrowers. Both the government and the commercial sector were tapping a common pool of resources and this was driving interest rates upwards," says Dennis Grubb, principal consultant with Price Waterhouse, who heads a project reviewing the operational problems of developing the debt market in India.
Nudged by an insistent central bank and as part of its market reforms, the government began offering market-related rates on its paper three years ago. Even though the reserve ratios of banks fell and the investment norms of insurance companies were relaxed, allowing them to invest less in gilts, the government's fiscal deficit has continued to remain high at around 6% of GDP. As a result its cost of borrowing climbed steadily, only easing somewhat this year since banks are flush with funds.
With interest payments spiralling, it made economic sense to broaden the investor base in gilts and allowing foreign investment is one way of doing this. "Broadening the investor base will pull down the government's cost of borrowing," Grubb points out. However, the Indian government has been wary of overdependence on external borrowings ever since India's balance of payments crisis in 1991 when its foreign exchange reserves dwindled to $2.3 billion and its debt service ratio hit 35%.
Its reluctance to open the floodgates fully is evident in the fact that it has kept treasury bills (short-term instruments which it issues for three months and one year) closed to foreign investors.
Only the longer-maturity government securities or dated gilts (with a maturity structure varying from two to 10 years), accounting for roughly Rs1,820 billion or 60% of the total debt market, has been opened up. The government has also said that foreign investment in debt (both corporate and government) will be subject to the annual ceiling ($7 billion for this year) on external commercial borrowing.
Fund managers want to know whether they will be allowed to bid in the primary auctions of government paper or whether there are any holding period restrictions on their investments. Although foreign institutional investors (FIIs) are allowed to invest proprietary (their own) funds this will be subject to certain regulation and it is uncertain what exactly this will be. There is also the question of the tax implications on earnings from fixed-income investments with one view holding that these will be taxable at 20%.
Others are concerned about structural weaknesses of the market such as the absence of an active secondary market, a depository, a repo market and a derivatives market. Plans to include debt instruments in the recently set up National Securities Depository could take a while. Operational issues need to be sorted out as trading in corporate bonds attracts stamp duty and the government bond account is settled through the Reserve Bank of India not the stock exchange.
But even the most sceptical observers agree that the Indian government is moving steadily to make these changes.
"Last September it seemed that the opening up of the government bond market to foreigners was at least a year away, but now we are talking of the operational aspects of how this is going to happen. It's slow all right but we are getting there," says a fund manager. Kala Rao