Allowing FIIs to raise investment in corporate debt instruments has significant implications
SOON after the lacklustre Union Budget was presented by Finance Minister P. Chidambaram Outlook (August 7) declared that behind the politically-balanced budget was his determination to usher in real reforms after the hue and cry subsided. In less than a month, the wily Chidambaram has more than vindicated that claim.
The day after the Bombay Stock Exchange (BSE) started its on-line retail trading in debt instruments (Outlook, September 4), the finance minister fired a salvo of reforms to buoy the sagging capital markets. Apart from the various tax concessions announced, he also allowed foreign institutional investors (FIIs) to raise investment in corporate debt instruments from 30 per cent to 100 per cent. Naturally, the FIIs are upbeat. Says Lester Pereira, director (treasury), Barclays Bank in Bombay: "The finance minister has ushered in an era that will have some exciting implications in the months to come."
Adds Sanjeev H. Shah, senior vice-president, DSP Financial Consultants: "The time is very ripe for local debt funds to take off. Once the guidelines are announced, several debt-dedicated funds will start looking towards India more viably." Agrees D.R. Mehta, Securities and Exchange Board of India (SEBI) chairman: "It will help to improve the debt market as dedicated funds would now come into the country." But that's the means to an end. And the ends are several.
The Stone and the Birds: Says a clearly impressed Pereira: "The finance minister has killed more than one bird with one stone. By allowing the FIIs into debt instruments which might bring in almost $5 billion in a year, the Government has not only thwarted the negative impact on the exchange rate, money supply and forex reserves, but by redeeming its bonds and forex deposits, it has also established the credibility of its financial commitments in the global economy."
While allowing 100 per cent investment in debt instruments, Chidambaram also declared that India Development Bonds (IDBs) would be redeemed in full this year. The IDB redemption, involving an outgo of $2 billion in foreign exchange, had been causing intense speculation. A possible rolling over the redemption on account of the balance of payment position might have affected India's credit rating.
Also due this year is the $3-billion redemption of FCNR(A) (Foreign Currency Non-Resident Account) deposits, which the Government had decided to phase out a couple of years ago. A total redemption due of almost $5 billion in one year is bound to severely impact the money supply, the exchange rate of the rupee and forex reserves. A situation that would now be eased with FII money flowing into debt instruments.
Higher FII inflows would also help ease the credit squeeze and lower interest rates. The RBI governor has already declared that interest rates will come down by 2-3 per cent in the next 12 months. The inflow of additional money will further help bring it down. Says Pereira: "The writing on the wall is clear—deposit growth is picking up while credit growth is not. FII inflow would further boost the surplus money in the market. We are heading for a liquidity surplus regime, like in 1994 when GDR money bailed out the economy."
The entry of FIIs will introduce much-needed volatility in corporate debt instruments. With equity markets sluggish, most cor- of porate houses will find secondary trading on debt instruments a viable source of funds. Says Shah: "The fact that FIIs are allowed in corporate bonds and not Government securities already precludes 60 per cent of the debt market from their reach. But the remaining 40 per cent is not a small amount either. What happened in equities when FIIs were first allowed could be repeated in the debt market." A lot, however, depends upon the guidelines that follow. "Issues like long-term capital gains, withholding tax, stamp duty and transaction cost will have to be sorted out," warns Swaminathan B. from Templeton Asset Management (India).
The Next Step: Most FIIs are insisting on a few infrastructu-ral requirements like trading should be scripless and hence the need for a depository for debt instruments. "Repos (ready forward purchase of securities) should be allowed in corporate debt, which over time could be extended to shortselling of debt papers," says Nikhil Johri, chief of Peregrine Capital (India)'s newly set up debt investment division. Post stocks scam, however, the RBI is not so sure. Last month, the Finance Ministry shelved the proposal to permit repos in all securities including public sector bonds. The apex bank also finds the deal tantamount to its funding the entire broking activity.
On-line trading and stringent monitoring could be a major deterrent to abuse of repos, but the dealers are worried abut the tenure of the foreign investment in debt securities, especially after reports of a three-year lock-in for repatriation of money. Says Pereira: "Unless they are allowed to start off the trading with short-term commitments, FIIs will be wary of trying out an untested debt market."
The other worry is the rupee-dollar exchange risk. Says Johri: "No FII will bring in any substantial money into the Indian debt market if there's no currency hedging option. The fear of rupee depreciation may just prevent large inflows." That doesn't deter too many though. "Despite rising inflation, India is still quite a lucrative market," says Pereira.
Rising Temptation: Internationally, funds for debt cost a few basis points above LIBOR (London Inter-Bank Offered Rate), while the cost in India is around 18 per cent. Presuming the effective cost of dollar at 6.5 per cent (in India at 17.5 per cent), a totally convertible rupee would give a spread of 11 per cent. Adjusting for 9 per cent inflation in India and 3 per cent in the developed markets, the effective spread would reduce by an additional 6 per cent. Explains Pereira: "The risk of currency depreciation is proportional to inflationary changes. Even if the rupee depreciates by 2 per cent more than the 6 per cent inflationary difference, there is still a 3 per cent spread." Which means the rupee will have to top Rs 41 from the present Rs 36 to a dollar in a year for FII profit hopes to be totally wiped out by currency depreciation. "The forex gained by the Government on account of FIIs alone would ensure that rupee doesn't depreciate so much," Pereira argues.
Little wonder then that the debt market is buoyant. Total debt funds raised in 1995-96 may well cross Rs 60,000 crore, which may trigger a fall in interest rates. Financial institutions are planning to jointly set up market makers for buying and selling debentures. The Government is also set to undertake a series of RBI-recommended debt market reforms. I-Sec is already planning a bond index. While Pereira is betting that funds in excess of $5 billion will enter into the country, "provided the ministry follows its announcement with real logistical reforms required," more conservative estimates hover around $3 billion. Round two then to Chidambaram!