10 Years a Slave; Its 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, liberalization of the debt market will provide the 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 liberalization, enforceability of rights has been a key bugbear for foreigner investors. The experience over the last 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, “what do we care about foreign investors losing money If they choose to invest in badly operated local companies, their lookout”. Foreigners were by and large seen as speculators and not investors and their money was shunned until the currency fell apart last year. Many NRI readers would have been approached over the last 12 months to invest in FNCR (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 on shore 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 quantums 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 endeavor 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 USD 1.5 trillion or 6% of GDP.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). This is a mind blowing figure by any country'sstandards, let alone a country which 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 Figure 1: The price of growth. Long term, high domestic cost of funding will encourage potential issuers to tap overseas investors Source: Bloomberg data Figure 1 shows India's yield curve i.e. the long-term interest rate profile of India. While the short end of the curve tells us what we all know - that growth outlook is likely to remain shaky for the next couple of years, markets believe that long term growth and interest rates will revert upwards. This means expensive funding costs for local companies, especially in the mid cap segment. Mid caps and small caps are an integral part of the nation's future growth ambitions and wider, cheaper funding options must be made available to them. 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 via which to gain exposure to the unfolding Indian story. For issuers (Indian PSU's 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 fledgling in size 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 USD 200-400 Billion in size (as I mentioned, accurate data is difficult to come by). The US Bond Market in comparison weighs in at a whopping USD 35 Trillion. The scope of growth for the Indian market (across all financing vehicles) is huge. See figure 2. Fig 2: “Despite solid aggregate demand and a rising consumer base, the depth of Indian markets lags the mature markets and even China. It languishes at the lower end of Asian emerging markets.” (ASIFMA) Source: ASIFMA 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) to access the India story. 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) of if you're an NRI, you have to possess an OCI card, pan card and cross a whole host of other hurdles before you can inject money into bonds. On top of that, foreigners are restricted to holding an aggregate total of USD 30bn in government debt and are also restricted in how much corporate debt they can hold. However, there is increasing momentum behind the idea of liberalizing the bond market and allowing it to grow. “India should introduce wholesale liberalization of rules restricting foreign investors from participating in the domestic bond markets”(Financial Times, Sept 2013).The 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 India 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. Enforceability, the experience with convertibles:The Indian Foreign Currency Convertible Bond (FCCB) market grew at a breathtaking pace from 2004 through 2009 (see Fig 3) going from near zero to approximately USD 25 bn 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 that point, 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 of the mid cap stocks did not recover from their 2008 lows and wide spread defaults hit the market (and unfortunately in many cases the discovery also 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 together with overly complicated rules around default events per the SEBI and 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 FII's now avoid Indian bonds as an investment option unless the issuers are well known blue chips or the issuance is linked to the monetization of Government holdings in PSU's. Figure 3: Mid Cap Need for Cheap Funding Drove Foreign Currency Convertible Growth Source: KNG data Currency weakness can wipe you out:The stalling of the economy last year sent the GBP/INR rate to all time highs. Any yield on rupee investments was completely obliterated (Fig 4). Fig 4: Investors, Beware Macroeconomic Risk Source: Bloomberg data 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. Figure 5 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. Fig 5: India Sovereign Yields remain at the top end of the spectrum - illiquidity premium Source: Bloomberg Figure 6: Example Eurobond Issues: Eurobond issuance is dominated by the banks sector Source: KNG Data Figure 7: Example Domestic Issues (INR): Non-agency bonds tend to yield 10-11% across the board Source: KNG Data 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 white elephant ever present in the room. Until India deals with problems of corruption and corporate malfeasance, India will never function efficiently as an economy. As this article goes to press, the Indian media are pointing to a likely landslide victory for Mr. Modi and the BJP. Regardless of the results of these momentous elections, we pray and hope for an administration that abandons the protectionist stance that has prevailed over the last ten years. It's the only way the Indian juggernaut can get back on track.

Arup K. Ganguly is a Managing Partner at KNG Securities LLP (KNG), a City-based specialist broker-dealer in fixed income and convertible bond products. It is today one of the most active secondary market brokers of mid-cap Indian convertibles as well as an arranger of primary financing for Indian corporates.