Forming new bonds

Indian Express, 16th October 2013

India must lift restrictions on foreign investment in rupee denominated debt

The global financial crisis has heightened fears about integration with global financial markets. For a country like India, which should inexorably open up further to global markets, an important task of policymaking is to identify the path of this integration. It lies neither in shutting out foreign capital, nor in recklessly opening up to dollar denominated debt, which has landed many a country in trouble.

A recent Sebi study on foreign investment in government bonds has recommended the removal of quantitative restrictions on foreign holdings of rupee denominated debt and moving towards a framework similar to the one for foreign portfolio investment in equity. In this study, my co-authors and I find that India's capital controls continue to be guided by concerns about debt and its maturity, rather than its currency denomination. For example, India has placed many restrictions on foreign investment in rupee denominated bonds, even though this is one of the safest areas to open up. This is because the currency risk is borne by the foreigner and there is a foreign appetite for rupee denominated debt. Currently, the restrictions include caps on the total amount of rupee denominated bonds that a foreigner is permitted to hold as well as limits that vary by investor class, maturity and issuer. These have been implemented through a complicated mechanism for allocation and reinvestment. The restrictions fail to meet the objectives of economic policy today and must be removed.

In 1991, India embarked on its integration with the world economy through trade and capital account liberalisation. A key idea behind the early decontrol measures was that debt inflows were dangerous and, therefore, strong restrictions need to be placed on them. Restrictions were imposed to shift the composition of capital entering India towards non-debt-creating inflows and to regulate external commercial borrowings (ECBs), especially short-term debt. As a consequence, while the framework for FDI and portfolio flows is relatively liberal, India has a number of restrictions on debt flows.

Over the past decade, the global thinking on debt flows has changed. The macroeconomic and financial instability in emerging markets following the crises of the late 1990s has led to increased efforts in these countries to develop local currency denominated bond markets as an alternative source of debt financing for the public and corporate sectors.

In the 2000s, emerging economies' domestic bond markets have grown substantially. The outstanding stock of domestic bonds now exceeds $6 trillion, compared to only $1 trillion in the mid-1990s. Along with this, foreign participation has also increased substantially over the last decade. In contrast, the Indian policy framework on debt flows, characterised by quantitative restrictions on foreign participation, has resulted in limited foreign investment. There is a strong case for opening up the local currency government and corporate debt market to foreign investors.

The present arrangement governing foreign borrowing comprises two parts. First, dollar denominated debt: India raises capital through foreign currency denominated debt via government borrowing (both bilateral and multilateral), ECBs by firms (including foreign currency convertible bonds and foreign currency exchangeable bonds) and fully repatriable NRI deposits. Second, rupee denominated debt: Foreign investment in rupee denominated debt takes the form of foreign investors buying bonds in the Indian debt market, which is denominated in rupees. This is subject to an array of quantitative restrictions. There are different limits for foreign investment in government and corporate bonds. This arrangement is further complicated by sub-limits across assets and investor classes.

The share of outstanding government bonds that are owned by foreign investors has risen through the years. As of March 2013, it stands at 1.6 per cent. In absolute numbers, foreign investors own Rs 700 billion or approximately $11 billion of Indian government bonds. At present, the quantitative restriction on foreign investment in government bonds stands at $30 billion. The small scale of foreign ownership implies a substantial upside potential. The internal debt of the government stands at Rs 48.7 trillion. Government securities account for 90 per cent of this amount. Even if the ownership of foreign investors went up by ten times overnight, to $110 billion, it would only amount to 16 per cent of the existing stock of bonds.

A comparison with other emerging economies shows that India greatly lags behind in the proportion of government bonds owned by foreigners. This raises questions on the structure of capital controls in the rupee denominated bond market.

The Working Group on Foreign Investment, chaired by U.K. Sinha, pointed out that the existing regulations create incentives for Indian firms to favour foreign currency borrowings over issuing debt denominated in rupees. It recommended easing the restrictions on rupee denominated debt as a safer way to manage globalisation. The Committee on Financial Sector Reforms, chaired by Raghuram Rajan, also recommended the steady opening up of rupee denominated government and corporate bond markets to foreign investors.

The Sebi study recommends that the existing framework of quantitative restrictions be dismantled. This will encourage greater engagement of foreigners in the government debt market. Since this is rupee denominated, the concerns associated with "original sin" and liability dollarisation do not arise.

If restrictions have to be imposed, the existing quantitative ones could be replaced by percentage limits on foreign ownership. This will enable greater foreign participation as the size of the government bond market increases. Foreign ownership should be capped at a certain percentage of the outstanding government debt, such as at 10 or 15 per cent. The government debt market should be made operationally similar to the equity market. The regulator should allow unrestricted investment till the prescribed limit is reached.

Under this framework, there should not be any distinction between asset classes within the prescribed umbrella limit. In addition, the framework should not create artificial distinctions between investor classes such as foreign institutional investors, qualified foreign investors, sovereign wealth funds, etc. The recent increase in the foreign investment limit in government securities to $30 billion is only applicable to specified classes of foreign investors. These restrictions should be removed. In addition, foreigners should be allowed to participate in onshore currency futures markets so that they can hedge their currency exposure.