Masala bonds : Will offshore lenders welcome? Read on...

Welcome agenda for India macroeconomic stability

The measures to liberalise ECB norms and activation of Rupee denominated "masala bonds" are giant steps in the right direction to remove structural woes on the macroeconomic fundamentals when India is setting up pace for sustainable growth momentum over 7.5% in FY17-FY19 and into double-digit beyond 2019. The relaxation in end use restrictions, broad-base of lenders basket and adjusting the spread to practical market reality are welcome moves.

The benefits to India are milti-fold:

(a) shift of borrowers credit/cash demand from onshore to offshore will not add to domestic liquidity pressure when RBI is vigilant on liquidity retaining Repo rate as operating policy rate. Such a liquidity pressure will turn resistive to its accomodative interest rate policy, having already delivered 1.25% cut in 2015 against limited space for 2016 and beyond.
(b) Attracting long term ECB and masala bonds (for tenor 3-10 years) is relief for Rupee exchange rate and to ring-fence FPI induced volatility and to cut frequent presence of RBI in the FX market. It is much needed when Rupee is more vulnerable to downside risks from ECB and FED walking in opposite direction in their monetary policy stance. The combination of weak EUR/USD and spike in USD interest rate will come very heavy on Rupee value against the USD. The risk from PBoC is also in the radar which continue to stay as unforeseen bolt from the blue.
(c) Shift of currency risk from domestic foreign currency borrowers to offshore Rupee lenders is long overdue measure for steady move towards full convertibility on Capital account. When Rupee is expected to face challenges from sudden bout of weakness and stretch beyond interest rate differential on annualised basis, it is systemic risk for domestic borrowers (and on domestic banks) on unhedged "carry" trade foreign currency liability exposures, and RBI has the need to mitigate this risk by offloading the same on foreign lenders.
(d) Rupee exchange rate volatility is driven by FDI mood-swings from sudden shift from India risk-on to risk-off and vice versa; seldom they remain risk-neutral for long period. This leads to stakeholders pain (real loss and/or opportunity loss) and RBI is forced to stand in guard eitherway to arrest excessive one-way price move to balance competitive interest between exporters and inflation. It is high time India cut this FPI induced short term volatility by attracting stable long term debt.

Will domestic borrowers lose the "carry trade" play or foreign lenders keen to take currency risk?

Most foreign currency denominated ECBs are not fully hedged. At the moment, most borrowers tend to keep 6M Libor cost open taking comfort from sustainability of low short term interest rates without the need to pay 6M to 3-10Y Libor hedge cost. Most borrowers also do not see the need to pay the elevated 5.5-6.0% swap cost for long term USD/INR currency hedge. If both the LIBOR and USD/INR hedge is done, it may not be cost effective to cover CDS risk premium and intermediation margin spread. Even if some space is left for good risk borrowers, the operation risks from marking to market & related periodic exchange of cash flows with Banks is not seen to be worth it. It is better to borrow in Rupees at fixed rate. Most AAA/AA borrowers have already moved away from ECB carry-trade play to interest rate arbitrage play in the domestic market. Taking comfort from declining short term money market rates, borrowers have increased appetite in 3-12M CP market (riding the down-hill from 8.75-9.5% to 7.5-8.25%) for decent cost arbitrage against stable 3-10 years long term fixed rate at 10-11%. This approach is now seen as low risk - medium reward against high risk - low reward nature on ECB exposures. All taken, while the demand for foreign currency ECB (from domestic borrowers) will be on decline, there will be less appetite for Rupee denominated masala bonds (from foreign investors). It will work only if foreign lenders could provide decent cost benefit over 10-11%. Can foreign lenders price masala bonds at fixed rate coupon of 8.5-9.5% for 3-10 years tenor?

Against demand for issuance of Rupee denominated Masala Bonds by Indian borrowers, need to review supply side appetite from foreign lenders at fixed coupon rate of 8.5-9.5% for 3-10 years for AAA/AA credit risk. The first look of it doesn't evince interest against CDS credit risk premium of 1.5-2.5% and current hedge cost of 5.5-6.0% (all-in at 7-8.5%), which leaves little for foreign lenders at 1.5-2.5% USD return for 3-10 years). The only option for the foreign lender is to keep the USD/INR exchange rate open to buy masala bonds. Will (or can) they? Long term Rupee exchange rate stability with an annualised depreciation of 3-4% is seen to be behind. The proof of the pudding is from the rate of Rupee depreciation in the last 2-3 years since 2012. The external dynamics will keep Rupee under pressure for annualised depreciation of 5-6% for next couple of years. All combined, foreign lenders preference will be on foreign currency lending with minimal appetite for Rupee exposure. The demand for taking on masala bonds into the Balance sheet will only be to test the water rather than as strategic preference.

Shift of appetite from offshore to onshore credit is there to stay through 2016

The demand-supply dynamics is complex; while domestic borrowers will prefer fixed rate short term Rupee credit (retaining interest rate arbitrage play from CP and short term demand loan credit products against fixed rate long term loans), foreign lenders appetite will be on long term foreign currency debt for encashment of elevated tenor premium. Given the huge credit appetite of domestic banks (with bandwidth for cut-throat pricing by shifting excess SLR cash to low risk - low reward credit), foreign lenders will find it tough to compete with India based lenders when short term US yields are set to inch higher. The only hope is from new entrants (into eligible investor category) who may not be adverse to pay entry premium for acquiring India risk assets/debt.

All taken, it is great initiative but need to be prepared for baby-steps start with hope for turn into giant steps beyond 2016-2017.

Moses Harding