India’s new government looks to unleash a fresh wave of debt funding to help meet the country’s chronic financing needs as bank lending dries up.
After the elections in May the Reserve Bank of India introduced a slew of measures to boost capital markets activity, including slashing withholding tax on bonds and relaxing capital controls.
These steps are expected to pick up the slack created by a drop in bank lending, with Tata Motors already taking advantage. The Indian group on Thursday sold a Reg-S $750 million dual tranche bond.
It is timely because loan growth slowed to 11.6% in August from 13.3% in July, the slowest pace since December 2009, after lenders stepped up efforts to lower bad debt from an eight-year high reached in 2013.
This is not ideal, especially given the fact that newly elected Prime Minister Narendra Modi needs to revive $255 billion worth of stalled infrastructure projects and as Indian companies seek financing for overseas’ expansion.
“You need to develop bond markets [rather] than just rely on the traditional loan market — even more so in a market where banks are capital constrained,” Vijay Chander, Hong Kong-based executive director for fixed income at Asia Securities Industry & Financial Markets Association (Asifma), told FinanceAsia. Asifma is an association which promotes the development of Asian capital markets.
Projects that have been put on hold include 76 power plants and 44 steel mills, according to the website of the Cabinet Secretariat, office of India’s top bureaucrat. Almost half of the projects are stuck because of labyrinthine land acquisition laws, lack of funds and raw material supply problems and will revive gradually, according to a May 15 note by Deepali Bhargava, chief India economist at Espirito Santo Securities India.
Getting projects rolling will need close coordination with local governments and once the issues have been ironed out, India will then see financing plans by local corporates take off.
This will add to the positive global fundraising momentum that has already been taking place. For example, debt-strapped infrastructure developer GMR Group is already in discussions with banks to raise $350 million by selling bonds to foreign investors. Citi, HSBC, JP Morgan and Standard Chartered are said to be managing the bond sale, according to market sources.
Credit ratings firm Moody’s predicts that the total value of foreign currency bonds issued by Indian corporates will reach about $13 billion to $14 billion for 2014 — a record high. The issuance could be even higher in 2015 if the cost of hedging exchange-rate risk declines, it added in a recent report.
As of September 10, Indian corporates this year had raised $8.7 billion worth of bonds denominated in dollars, euros or yen, according to Dealogic data. This is 31.8% higher than in the same period last year when $6.6 billion of so-called G3 bonds came to market.
Reforms ahoy
The cut in the withholding tax imposed on foreign currency bond issuance to 5% from 20%, which came into effect on October 1, is the most meaningful of the reforms undertaken so far. Previously, only infrastructure companies were allowed to tap the bond market at a tax rate of 5% but that has now been extended to all borrowers.
“The high 20% tax had been a major barrier for Indian companies issuing foreign currency bonds because the debt issuer makes the tax payment over and above the coupon on the bonds,” Vikas Halan, senior credit officer at Moody’s, said. “Debt issuers structured deals to bypass the withholding tax, but only companies with meaningful foreign assets and cash flows were able to structure such deals.”
The Indian central bank has also restored the level at which offshore Indian entities can raise foreign currency debt to 400% from 100% of the parent company’s total net worth, easing some of the capital controls imposed after the Federal Reserve telegraphed its tapering intentions in 2013 that prompted strong emerging market outflows.
The changes will benefit corporates looking to expand their businesses globally. “As more of these companies gain access to offshore capital, they will look at how they would expand internationally and make some strategic acquisitions whilst doing that,” said a Hong Kong-based head of bond syndicate.
Looming challenges
Although some capital market regulatory anomalies in India have been addressed, challenges still exist that could limit the type of borrowers that could come to market.
High hedging costs, for example, remain a major deterrent. Interest rates on foreign currency borrowings are lower than interest rates on Indian rupee borrowings, but the cost of hedging against currency fluctuations makes it more expensive for Indian entities to borrow internationally.
As a result, syndicate bankers expect companies in the oil, gas and mining sectors to continue driving the increase in issuance. That’s because they have a natural hedge against exchange-rate risk and do not need to swap their foreign currency borrowings into local currency. The same goes for India’s pharmaceutical and technology companies because they derive a large part of their revenues from exports, which are typically denominated in US dollars.
“For businesses with net US dollar cash flows, it makes a lot of sense to raise financing in the US dollar bond markets as they will enjoy much lower cost,” Neville Fernandes, head of DCM, Citi India told FinanceAsia. He adds that borrowers with rupee-hedging needs could be looking at overall effective costs of around 12%, which is higher than the average cost of Indian rupee bank funding of 11%.
However, Moody’s highlighted in a recent report that hedging costs have started trending down since the beginning of the year. If the recent stability of the Indian rupee causes the cost of hedging exchange-rate risk to decline sharply to around 2% to 3% from about 5% currently, more Indian companies will find it cost-effective to issue bonds in foreign currency.
Another limitation is the fact that the RBI has imposed credit limits on Indian borrowers. For bonds with tenors of five years or less, total costs cannot exceed 350bp plus Libor. For bonds with tenors over five years, borrowers cannot pay more than 500bp above Libor.
That creates a barrier for lower-rated Indian credits.
“I see this limit as a filter for Indian corporates,” Moody’s Halan told FinanceAsia. “I don’t see a lot of single-B issuance coming out of India because of this,” he said, adding that single-B issuers pay around 600bp or more for a bond at
the moment.
Light at the end of the tunnel
There is still hope even for these junk bond issuers despite the challenges. Over the last few months, credit spreads have tightened, meaning that local issuers might be able to easily overcome the credit limit issue, syndicate bankers said.
This could also help to address another concern arising from one of the RBI’s recent reforms. At the end of August, the Indian central bank relaxed limitations imposed on local issuers’ foreign currency funding — known domestically as external commercial borrowings (ECBs).
Indian companies are now able to refinance their existing ECBs with longer tenor instruments as long as their overall, average all-in cost is equal to or lower than the outstanding instrument. Previously, entities could only replace their existing ECBs with instruments of the same duration.
The JP Morgan Asia Credit Index (JACI) India Blended Spread, an index of credit spreads on US dollar-denominated bonds issued by Indian companies, was 249bp as of August 18. The spread has tightened by 68bp or 21% since the beginning of the year.
The reason for lower credit spreads is fairly simple — global investors have been pouring billions of dollars into Indian debt thanks to Modi’s landslide win in May. His coalition government has raised expectations of a brighter economic outlook for India.
The early evidence already supports this, with the economy expanding by 5.7% in the three months to June 30 compared with 4.6% in the previous quarter — its fastest annual pace in more than two years.
Morgan Stanley expects India’s GDP growth rate to hold at 5.7% over the remainder of the 2015 Indian financial year ending March 31 but sees a further pickup to 6.5% and 7%, respectively, in financial years 2016 and 2017.
“These are all very important changes and clearly very much liked by the market,” Citi’s Fernandes said, adding that he expects to see Indian issuers potentially raising around $5 billion in the last quarter. “India is in a sweet spot within emerging markets, thanks to the stable political environment, strong central bank measures, improving macro trends and a constructive outlook.”
