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By Niloufer Lam and Soummo Biswas
The main source of capital for Indian corporate expansion has traditionally been the strong domestic bank loan market. Ceiling limits have been imposed however on the exposure of banks to a single borrower and a borrower group. The existence of a vibrant debt capital market is important from a macro-economic perspective to provide mechanisms for greater sources of financing and liquidity and for risk minimization in any economy. In India, while equity capital markets have developed significantly in terms of liquidity, infrastructure and regulatory framework, the debt capital markets have traditionally lagged behind. For instance, whereas the Indian bond market was 3.2% of the Gross Domestic Product (“GDP”) the Indian equity market was 108% of GDP in 2009. In terms of the ratio of issued corporate debt to GDP in 2010, even the most developed and largest markets in the Asia Pacific region like China (10%) and Japan (42%) are still far smaller than the U.S. (129%), but with India at less than 5%, and as Asia’s second largest economy, the potential for growth is abundantly evident. We believe the foundations have been laid for the corporate debt market in India as well as other innovative types of financing to boom over the next decade. From a macro-economic perspective, the development of the domestic bond market would result in less systemic stress for both banks (viz depositors) and corporates (for their sources of funding). This is to say that the bank and bond markets can act as backstops for each other. They facilitate financial intermediation, put providers and users of capital together and make the credit evaluation process more transparent. The high and growing savings amounts of customers in India (who would want higher yielding instruments than bank deposits) together with the approximately 9000 listed companies is a powerful combination. In this context, one of the major contributors to the development of any capital market in the world is the infusion of foreign investment. In India, one way in which this happens is by way of investments by foreign institutional investors (“FIIs”).
While investments by FIIs in the equity markets have been facilitated to a great extent, FIIs having been placed at an equal footing with domestic investors, there seems to be a combination of “carrot and stick” approach on the debt market side. Though the government has been increasing the corporate bond debt limits for FIIs over the past few years, in this article, we seek to analyze two areas where FII investments have traditionally been affected and how the regulators have addressed both recently. While one is favorable and helps to encourage FII investment in the debt capital markets and the consequential development of the debt capital markets in India, the other does hamper FII investment in the debt capital markets.
Purchase of unlisted debentures: Building new bonds
Under the Securities and Exchange Board of India (Foreign Institutional Investors) Regulations, 1995, (“FII Regulations”), an FII has been defined as an institution established or incorporated outside India that proposes to make investments in securities in India. According to the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000 (Notification No. FEMA 20/2000-RB) as may be amended from time to time (“FEMA 20”), FIIs are permitted to purchase, on a repatriation basis, inter alia, non-convertible debentures/bonds (“NCDs”) which are listed and issued by an Indian company, either directly from the issuer of such securities or through a registered stock broker on a recognized stock exchange in India subject to such terms and conditions mentioned therein and limits as prescribed for the same by the Reserve Bank of India (“RBI”) and the Securities Exchange Board of India (“SEBI”) from time to time. The inconsistency that arose earlier is that since listing is effected post allotment, at the time of subscription the NCDs are not in fact listed and therefore do not fall within the relevant automatic foreign exchange permission for FIIs. SEBI had way back in 2010 allowed FIIs to invest in primary debt issues if listing is committed to be done within fifteen days of issue. Further, it was provided that in the event that the debt issue cannot be listed within fifteen days of issue for any reasons whatsoever, then the holding of FIIs/sub-accounts if disposed off shall be sold off only to domestic participants/ investors until the securities are listed. However, the changes were not at the time affirmed by the RBI and were not reflected in either FEMA 20”), or by way of any notification issued by the RBI. Therefore, FIIs, though permitted by SEBI were not allowed to directly subscribe to ‘to-be listed’ NCDs as whilst the securities market regulator had permitted the same, the financial services regulator had not approved of the same at that time.
Interestingly, RBI had initially permitted the issuance of NCDs with original or initial maturity up to one year and issued by way of private placement to FIIs, only subject to the limits specified by SEBI from time to time. Subsequently, however, the RBI made such issuances subject to the extant provisions of the Foreign Exchange Management Act, 1999 (“FEMA”) and rules, regulations, notifications, directions or orders issued thereunder in addition to the limits specified by SEBI. This added to the uncertainty regarding FII investments in unlisted NCDs despite SEBI’s relaxation of the rules in this regard.
Further, certain exceptions have been made in recent times which also established that RBI had to in fact affirm any direction by SEBI as far as FII investments were concerned. Both SEBI and RBI allowed FIIs to invest in long term unlisted NCDs issued by companies in the infrastructure sector (“Infra Bonds”) provided that the Infra Bonds have a minimum residual maturity of five years and are subject to a minimum lock-in period of one/ three years during which the FIIs will be allowed to trade amongst themselves but cannot sell to domestic investors and are subject to certain prescribed limits. We assume that this is to facilitate development of different capital sources for India to meet its infrastructure target of US$1 trillion for the next five year plan from 2012 to 2017. Subsequently, the ambit of eligible issuers of such Infra Bonds has been expanded to cover Infrastructure Finance Companies registered with RBI. While this was a step in the right direction, it was of utmost importance that FIIs be allowed to subscribe to primary issuance of NCDs issued by companies not in ‘infrastructure sector’ as well as it will help several issuers belonging to those sectors (which also require capital infusion along with the infrastructure sector) to access money from FIIs who wanted such debt exposure.
However, by way of a recent RBI notification on March 1, 2012 FIIs can now purchase ‘to be listed’ NCDs if listing is committed to be done within 15 days of such investment. It further provides that in the event NCDs are not listed within 15 days, the FII/sub-account of FII shall immediately dispose of these NCDs either by way of sale to a third party or to the issuer i.e. the same conditions that were prescribed by SEBI almost two years back. This amendment eases the process to attract quicker investment for the companies and will assist in the deepening of the debt capital markets. Unlike equities, our understanding is that NCDs are rarely traded and facilitating FIIs may increase number of investors with positive effects on liquidity and price discovery.
FIIs pay to invest in debt?
The other area where FIIs are disadvantaged, is the expensive process of actually subscribing to NCDs by FIIs. In order to invest in NCDs in India, an FII first needs to obtain the debt investment limits. While part of the investment limit is allocated by SEBI by way of an open bidding process, the remaining investment limit is allocated on a first come first served basis, subject to the conditions and procedure stipulated in the circulars issued by it from time to time in this regard. For instance, these limits were recently purchased by FIIs via the bidding process pursuant to a notification dated November 18, 2011. The maximum allocation limit for a single registered FII by bidding process as well as first come first served basis is changed frequently by SEBI. The government has set the cumulative debt investment limit in corporate bonds (including Infra Bonds) for FIIs at U.S.$45 billion and at U.S.$15 billion in government securities. This process not only limits the ability of FIIs to invest in the NCDs as FIIs are first required to procure debt limits before purchasing NCDs in the market but of course eats into their net return as the bid price paid is a cost to the FII. Whilst such an arrangement not only places an undue burden on the FII as opposed to other domestic investors, it also disrupts the price discovery of NCDs by the market as far as FII investment in NCDs is concerned since FIIs are required to factor in the time and cost required to procure debt limits which is external to the market.
This situation has been further exacerbated recently. FIIs originally enjoyed a period of five business days, subsequently increased to fifteen working days for replacement of the NCDs that have either been disposed off or matured. In other words, FIIs could reinvest the proceeds received on the expiry or sale of the initial NCDs into new NCDs provided such investments were made within the period of fifteen working days. This re-investment facility has however been discontinued by SEBI since January 3, 2012, as a result of which re-investment period shall not be allowed for all new allocations of debt limit to FIIs or sub-accounts. As regards debt limits that have already been acquired and/ or invested in debt previously acquired, the facility of re-investment will continue for the FIIs until any one of the following thresholds is breached: (a) total sales made from the existing debt portfolio (current debt investment and the un-utilized limit currently with the entity, if any) is twice the size of its debt portfolio as on the date of the circular; or (b) expiry of two years from the date of the circular i.e. January 2, 2014.
Thus, debt limits paid for and acquired by FIIs in the bidding sessions will expire or lapse on either sale or at maturity and will be allocated in subsequent bidding processes. The FII now needs to purchase debt limits every time he wishes to buy NCDs which given auction frequencies also affects their annualized return since such amounts will remain un-invested for a period following sale or redemption of NCDs. Further, the move could discourage investments by FIIs in short term debt instruments and lead to a gap in the short term debt market as any FII would now seek to invest only in long term debt instruments.
There have been a number of reports on the corporate bond market in India, the first one being “The Report of the High Level Expert Committee on Corporate Bonds and Securitization”—commissioned by the central government and chaired by R. H. Patil in 2005. There have also been a number of regulatory reforms to promote the corporate bond market such as easing of issuance and listing requirements, clearing of bonds through stock exchanges, market infrastructure technology changes, reduction in trading lots, repos in corporate bonds, development of the foreign exchange and interest rate derivative markets, introduction of credit default swaps and the most recent one of allowing FII investment in primary issuance of debt. The central government, various regulators and financial institutions have been the key participants involved in building the corporate bond market in India. Several measures have been taken as described above to promote the FII investment as well. Nevertheless in our view there are additional areas with respect to FIIs where there are some easy fixes. The same would greatly enhance the FII inflows into the country given the rise in global liquidity and the attractive interest rates, yields and valuations in the corporate bond market in India.
Niloufer Lam is a Partner and Soummo Biswas is an Associate with Amarchand Mangaldas.