Maple, Masala, Dim Sum topped with Kimchi followed by Baklava may sound like an unusual and slightly brave tasting menu. They are however a list of international bonds and following a series of foreign-denominated offshore bonds conceptualised before it, Masala Bonds were introduced in 2014 by the Indian government and International Finance Corporation. The plan was for these to help contain the current account deficit, fund infrastructure projects, fuel internal growth and internationalise the Indian rupee. So has this worked in practice or has the theory remained academic?
What are Masala Bonds and how do they work?
Masala Bonds are financial instruments through which Indian entities can raise money from offshore markets such as the London Stock Exchange. Unlike conventional bonds, these are rupee-denominated but settled in a foreign currency, so the currency risk is transferred from the issuer to the investor. The term “Masala” has been ascribed to these bonds to give them an Indian tone whilst the Chinese and Turkish variants for example are respectively known as “Dim Sum Bonds” and “Baklava Bonds”. The Reserve Bank of India set out guidelines allowing Masala Bonds to be issued by Indian companies, Real Estate Investment Trusts and Infrastructure Investment Trusts. Legally they are defined as debt securities and typically governed under English law.
So a game-changer for the Indian economy?
The emergence of Masala Bonds as a funding vehicle for Indian entities had been cited as seminal moment for the economy, especially against the backdrop of low-interest rates in established western markets. Theoretically at least, this heightens the appeal for the higher-yielding emerging market debt. An arguable example is the recent 9.72 percent coupon rate issued by the Kerala Infrastructure Investment Fund Board, raising $312m. Such capital raises and many more hoped like it had been forecasted to be a game-changer for the Indian economy, sparking critical infrastructure projects for government agencies, and much-needed resources to invest in new products and services for Indian corporates.
Moreover, the cost of borrowing for Indian entities can be significantly lower in foreign markets allowing access to larger, more liquid and less regulated capital. For Indian corporates, structural deficiencies and stringent security requirements within the internal bond market, for example, can make raising funds through it problematic, economically inefficient and thus typically used as a last resort.
In addition and perhaps most critically, by function of Masala Bonds being denominated in Indian rupee, Indian entities can eliminate any currency depreciation risk. This can be significant as was the case through periods of 2018 when the rupee experienced swings of 10 percent plus against the US dollar. Under these circumstances, debt issued via traditional offshore bonds could have been crippling for Indian entities. Masala Bonds also encourage globalisation of the rupee as foreign buyers would need to deal more with the currency when purchasing the bonds.
The other side of the coin…
Practically, however, the transfer of this currency risk onto investors has resulted in a need to hedge the transaction. The volatility of the rupee means that the cost of this can be expensive, averaging 5-6 percent. This process requires non-deliverable forward (NDF) contracts transacted offshore. These derivative instruments allow for trading to be done in restricted currencies such as the rupee by serving as the underlying asset, but without actual delivery of the currency. The underlying asset never exchanges and the contract is settled by paying off the difference in exchange rates. The final positions are then settled by paying in fully convertible currencies such as USD, GBP, or EUR. As a result, the net yield is eroded and thus the business case of investing in Masala Bonds reduced. An investor may also need to factor in the credit risk of the issuer, potentially requiring them to enter into credit default swap (CDS) contracts also adding to the cost of the transaction, reducing any potential margin.
A further concern for investors could be the process known as seigniorage where a weakened currency is used to pay off outstanding debt. Debt issued in a country’s own currency lends itself to inflation risk and technically the debtor can simply print more money to repay it. The consequent impact of this could mean that if a bond was set to earn 10 percent interest but a currency value is 20 percent lower, the investor actually loses money in real terms. This adds to the scrutiny required from investors with bonds issued in a foreign currency.
Evolving government policy and the future
At the time of inception in 2014, the then finance minister Arun Jaitley cited $1.5 trillion in infrastructure spending needs over the forthcoming decade. The issuing of Masala Bonds was a central component of the strategy to enable this and the government reinforced this approach when it later issued policy refinements reducing the withholding tax on interest income from 20 percent to 5 percent. More widely, other initiatives such as the 2016 Insolvency and Bankruptcy Code have strengthened and helped develop a more efficient functioning domestic bond market. This in-turn indirectly adds support and appeal for the offshore listed rupee-denominated debt.
Despite these policy enhancements, however, the overall adoption of Masala Bonds as a capital raising mechanism for Indian entities remains low. One practical illustration of why this has been the case can be seen with the HDFC Masala Bond listing in 2016 where the headline yield numbers arguably mask the true return since the issuer itself was forced to absorb the 5 percent withholding tax to entice demand. This is a cost that would have otherwise been paid by the investor.
The impact of tightening global liquidity and the side effects of demonetisation cannot be underestimated. Perhaps once these have truly subsided the Indian economy will turn a corner, but in the meantime, foreign investors can understandably be cautious given the recent history of developing nations such as Argentina and Russia defaulting on domestic currency bonds. Coupled with this, the rupee ultimately needs to stabilise, underpinned by strong macro-economic fundamentals before Masala Bonds can become a truly effective tool in enabling foreign capital inflows.
Shiv Morjaria is lawyer for an Investment Bank.