Friday, August 21, 2015

Improving the Regulatory Framework Governing Masala Bonds

[The following post is contributed by Dhanush. M, a 5th year student at the Jindal Global Law School]

“Masala bonds” refers to rupee denominated bonds issued in offshore capital markets which would be offered and settled in US dollars to raise Indian rupees from international investors for infrastructure financing in India. Masala bonds could prove to be a viable source of corporate finance as they shift the exchange rate risk to investors. Masala bonds also serve the policy objectives of the Reserve Bank of India (RBI) of integration of the Indian economy into the global economic system and internationalisation of the Indian rupee.

The `Draft framework on issuance Rupee linked Bonds Overseas` issued by the RBI links the issuance of masala bonds to existing regulations governing external commercial borrowings (ECBs).  Investors in these bonds will be eligible to hedge both the foreign currency risk as well as credit risk through permitted derivative products in the domestic market. Investors can also access the domestic market through branches of Indian banks abroad or branches of foreign banks with Indian presence.

In addition, borrowings of three to five years have a price cap of 350 basis points over six-month Libor and those of more than five years have a price cap of 500 basis points over six-month Libor. Banks incorporated in India will not have access to these bonds in any manner whatsoever.

The treatment of Masala bonds through the ECB regulations restricts the growth of the market quantitatively in relation to the maximum amount of money a firm is eligible to borrow externally, and qualitatively in relation to the end-use, tenure, maturity  and all-in-cost ceiling restrictions. The recommendations made by the Sahoo committee suggested that ECB restrictions of end-use, maturity, tenure and all-in-cost ceiling do not have nexus to the stated objectives of addressing market failures. In other words, the ECB restrictions should be abolished.

ECB access should only be denied to sectors where FDI is banned, such as gambling, lottery, chit funds, real estate or construction of farm houses and manufacturing of tobacco products. Alternatively, to regulate foreign currency inflows into India, the existing guidelines on foreign ownership of Indian companies would suffice.

In the case of Masala bonds, since the exchange rate risk is shifted to the foreign investor, the investor typically hedges its investment through currency and credit derivatives. Therefore, it is important that the strength of the currency derivatives market be improved through the introduction of more instruments, widening the base of the participants through commensurate regulations along with modern risk management systems and improved customer service.

Additionally, there is a need to increase liquidity in long-term hedging products. Development of markets for long-term hedging products is necessary to reduce risk in the system. Use of most advanced payment and settlement infrastructure in the forex market is required along with improvement in other market infrastructure.

Also, the cost of hedging should be optimised to the investors so that the gains from interest on bonds are not frittered away in derivative transactions, such that subscribing to masala bonds becomes financially unviable. The cost of hedging would be reasonable only if there is a deep and liquid well-functioning onshore currency derivatives market. To develop a liquid secondary market for Masala bonds, there is need for a benchmark yield curve across maturities because lack of pricing in the secondary market is not observable across maturities which has an enormous impact on liquidity.

With regard to the use of options as a hedging instrument, while there is increasing interest amongst end-users in using currency options, not many banks in India have scaled up their expertise in this area and the option activity remains confined to just a few banks. This prevents the development of an active options market. It is necessary that banks enhance the relevant skill-sets in this product which have been strongly favoured by investors.

As for the market for credit derivatives, there is a need for expansion of the list of market participants and the list of debt instruments on which credit default swaps (CDS) can be written. Also, the liquidity of the currency underlying in India needs to be strengthened.  It is important to expand the scope of the currency derivatives market by including unlisted corporate bonds as users of CDS and one should allow CDS on unrated bonds and loans.

Furthermore, there is a need for clarity on tax treatment of Masala bonds. In RBI's draft framework, there was no mention of the tax treatment on Masala bonds, as a decision on this can be taken only by the revenue department.

Currently, there is a withholding tax for foreign institutional investors of five per cent for in ECBs, as well as in domestic corporate bonds. If companies seek raise capital through this platform without clarity on the taxation aspects, they would end up paying a higher coupon rate, due to which it might become financially unviable. Ideally, it may be worthwhile to award exemption to foreign investors from withholding tax to incentivize their participation in masala bonds.

As per existing regulations, a long term equity share held for more than one year and on which securities transaction tax (STT) is paid  would be exempt from tax (Section 10(38) of the Income tax act, 1961). A similar provision could be extended to Masala bonds.
It would be very beneficial to the masala bond market if the fixed cap on coupon rate is removed gradually over a period of time as fundraising by high yield issuance would be difficult for small and medium scale companies who stand to benefit the most from a vibrant masala bond market.

I conclude stating that the aforementioned recommendations would be positive changes to the Masala bond market.  However, the changes have to be coupled with positive steps to improve on the institutional shortcomings like the bankruptcy code, creditor rights, clearing and settlement agencies that could impede the growth of the Masala bond market.

- Dhanush. M

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