Like an actress dressed in the tattered clothes of a pauper, there is something incongruous about India’s stunning economic success over the past decade. The country is on a winning streak, but according to one recent survey the country ranks below war-torn Côte d'Ivoire when it comes to infrastructure, which is in serious need of some retail therapy.
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With crumbling roads, ports and power networks shaving an estimated 2 percentage points from the country's growth each year, Indian politicians have promised a 'decade of infrastructure', with $1500bn allocated to various projects. Explicit in the plans is a commitment to expand the country’s capital markets, which trail their Asian peers in terms of development.
The new policy is beginning to bear fruit and India's state-run Power Finance Corp has recently mandated dealers for an inaugural offshore medium-term note programme, after receiving central bank approval to raise $1bn from international investors.
Small fry
Still, India’s debt market remains a relative minnow, with corporate borrowings weighing in at about 3.3% of the country's gross domestic product, according to the country’s Associated Chambers of Commerce. The comparative figure is 10.6% in China and 42% in Japan. The total amount of Indian corporate debt outstanding is about $200bn, according to Asian Development Bank figures, compared with China’s $614bn.
India’s relatively anaemic bond market is partly the result of highly cash-generative businesses, and a traditionally strong relationship-driven loans sector. But it has also been restricted by a small investor base, regulatory restriction and red tape.
“The economy has been growing very quickly with companies generating high levels of cash flow, and to some extent they have chosen to reinvest rather than go out and raise debt,” says Henrik Raber, global head of debt capital markets at Standard Chartered.
Regulation hits returns
A key restriction on the market has been tight controls around levels of foreign investment in fixed income. In September, the Indian government increased the overall limit for corporate bonds held by foreign institutional investors to $40bn, a significant rise from the previous level of $30bn, but still a drop in the ocean against the country’s infrastructure needs.
Under the new programme, foreign investors can invest up to $25bn in long-term infrastructure bonds with a minimum residual maturity of five years and a lock-in period of one year or three years, during which time the investors can trade among themselves but cannot sell to domestic investors.
The new scheme was the latest attempt to attract overseas funding to India, after a more restrictive earlier version led to just $109m of foreign investment into corporate infrastructure bonds in the eight months up to August 2011.
Tax issues
One reason for lacklustre levels of international interest is a withholding tax of as much as 20% payable by foreign investors on interest and redemptions. By way of comparison, fund managers can earn a 12% yield on a 10-year Brazilian government bond, which has no withholding tax, but only 6.75% after withholding tax for a similarly dated note in India, on which the credit rating is one notch lower.
“The authorities have introduced some measures in an effort to attract foreign investors, which has to be seen as an encouraging sign, although the lock-in periods and withholding tax rules do present challenges,” says Saurabh Jain, an executive director at Nomura India. “In order for the bond market to reach its full potential these issues need to be resolved, but it is not going to happen overnight.”
Withholding tax does not apply where borrowers use the proceeds of bond issuance outside India, and the difference that can make was illustrated by the successful sale last year by conglomerate company Reliance Industries of $1.5bn of 10- and 30-year notes to fund the purchase of US shale gas assets.
New tools for bond investors
Pension funds and insurance companies in India are restricted in how much they can invest in bonds, while a thin secondary market also deters foreign investors from doing so, analysts say, with most existing infrastructure bonds held in buy-to-hold accounts. Unlike loans, banks must mark bond holdings to market.
Despite the difficulties, circumstances are now combining to offer the India bond markets another shot at establishing a meaningful presence. The primary driver is chronic infrastructure needs, with the long-term tenors offered by bonds a relative advantage over loans in major building projects.
A further boost has been indirectly provided by India’s feverish economy. Inflation rose to 9.78% in August, its highest level in a year, caused by the rising cost of food, fuel and manufactured goods. Concern over inflation has prompted the Reserve Bank of India – India's central bank – to raise interest rates 11 times in the past 18 months, and spiralling interest rates have fed directly into loans, with one estimate now putting them some 125 basis points costlier than bonds.
Government encouragement
Meanwhile, the Indian government has done its best to encourage wider bond market participation, and progress is being made in the development of repo and credit default swap markets, set to be introduced in October 2011.
The combined effect of rate rises and official mandate has tempted previously reluctant Indian corporates into dollar bond sales, despite rules restricting the use of dollar-issuance proceeds to capital projects. Tata Group and Vedanta are among corporates to have tapped the dollar markets this year.
As the popularity of foreign-currency issuance has risen, however, local currency bond sales have slowed. There has been $6.7bn of corporate rupee-denominated issuance this year, according to data provider Dealogic, compared with $10.5bn in the whole of 2010. Dollar-denominated bond sales, meanwhile, total $3.2bn for 2011 up until 2011, compared with $2.4bn for the whole of last year. There is cap on overall corporate overseas borrowing of $30bn per year.
New currencies
Amid the increased enthusiasm for overseas bond sales has come a taste for alternative currencies, with the Swiss franc proving a popular option. Indian public infrastructure finance company Rural Electrification Corp was reported in early September to be considering a roadshow for a Swiss franc bond, which would make it the fifth Indian borrower to tap the market this year
In a significant move in September, new rules increased the amount that individual Indian companies are permitted without approval to borrow overseas from $500m to $750m. The rules also introduced foreign currency refinancing of rupee debt and allowed a limited amount of borrowing in Chinese yuan, out of Hong Kong’s flourishing 'dim sum' market.
“We see strong opportunities in the renminbi market,” says Standard Chartered’s Mr Raber. “With the growing trade ties between India and China, issuance in Hong Kong is a natural first choice, particularly for corporates.” Chinese banks are already active in the Indian loan markets, and Industrial & Commercial Bank of China recently opened its first Mumbai branch, while State Bank of India last year launched in Shanghai.
Indian infrastructure and finance company Infrastructure Leasing & Financial Services looks set to be the first company to issue an Indian yuan-denominated bond, after it reportedly chose three banks in August to manage a $200m-equivalent deal.
Competitive bidding
As India’s bond market at last begins to gain momentum, investment banks could be forgiven for rubbing their hands together in anticipation of a potentially lucrative new product line. However, the reality is somewhat different, with experience suggesting it will not be companies paying banks to manage bond sales, but vice versa.
League table trades with low fees are common in Asian capital markets, and India is a leading proponent of the art of extracting banking services for minimal or zero outlay. However, for many banks, low or non-existent fees are a price worth paying to win market share.
“The competition to win mandates among underwriters on debt capital market transactions has historically been very fierce in India compared with Asian counterparts, in particular when it comes to issuance from public institutions,” says Nomura’s Mr Jain. “There can be an opportunity for banks where alongside the sale they provide a swap or other derivatives, but often pitching is driven by league table priorities.”
India’s state-run companies often require arrangers to attend physically at beauty parades for new mandates, with the lowest bidder winning, often by quoting fees at zero. Typically, issuers will indicate only a minimum deal size, asking banks to suggest how much paper should be issued, or upsizing deals at the last minute.
As banks mull the fees conundrum, bond markets may take encouragement from recent progress toward a role in building the new India. However, until issues such as capital controls, regulatory curbs and restricted liquidity are fully resolved, they may have to settle for a cameo role.
