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RBI’s Plan To Lure Foreign Investors Towards State Bonds Flops

Only 8 percent of the limit available to foreign investors has been used



Indian rupee and U.S. dollar banknotes (Photographer: Dhiraj Singh/Bloomberg)
Indian rupee and U.S. dollar banknotes (Photographer: Dhiraj Singh/Bloomberg)

A year after the Reserve Bank of India opened up the market for state government bonds to foreign investors, there have been few takers for this debt. Despite offering yields that are higher than central government bonds, foreign investors remain uncomfortable about state finances and liquidity in the secondary market for these bonds.

According to data from the National Securities Depositories Ltd, only 8 percent of the limit permitted for foreign institutional investors (FIIs) has been taken up. Foreign investors are now allowed to purchase upto Rs 17,500 crore in state bonds. The market was first opened up in October last year when the RBI said FIIs can buy up to Rs 3,500 crore in state bonds. Since then the limit has been steadily increased each quarter with the intention of allowing foreigners to hold up to 2 percent of the outstanding pool of state bonds by March 2018.

FIIs, however, appear to be completely disinterested. While there was some interest in the bonds when the first tranche was opened up, subsequent tranches have not attracted any interest.

In contrast, the limit for central government bonds has been completely used with 97 percent of the limit exhausted. In the corporate bonds category, 75 percent of the limit has been used.

The problem with FIIs is that they don’t want to take any additional risk. They are already taking currency risk when they come here and they don’t want to add to that. So they tend to cherry pick and invest only in the purest form of sovereign debt i.e. central government bonds.
Lakshmi Iyer, Head - Fixed Income, Kotak Mutual Fund
RBI’s Plan To Lure Foreign Investors Towards State Bonds Flops

Yield Differential Does Not Reflect Increased Borrowings

Historically state government bonds have traded at yields which are about 30-50 basis points higher than the comparable central government bonds.

At Tuesday’s auction, 10-year state development loans (SDL) or state bonds were auctioned at coupon rates between 7.21-7.27 percent compared to a yield of 6.75 percent on 10-year government bonds.

This yield differential has remained fairly static, barring an exceptional auction or two earlier this year when fears about increased state government borrowings on account of the UDAY (Ujwal Discom Assurance Yojana) scheme had pushed up state yields. Since then, the difference between the two has normalised even though state government borrowings remain elevated.

Over the last two fiscal years alone, state government borrowings have risen by close to 35 percent, shows data from the Reserve Bank of India. Central government borrowings over the period have been largely steady.

RBI’s Plan To Lure Foreign Investors Towards State Bonds Flops

Over a longer period of time, the jump in state government borrowings has been even more dramatic. Outstanding market loans for state government have risen from Rs 2.6 lakh crore to over Rs 15 lakh crore in just a decade.

Soumyajit Niyogi, associate director for credit and market research at India Ratings & Research notes that there are a few structural reasons for limited foreign investor interest in state bonds including limited clarity on the underlying fiscal position of states and the difficulty in differentiating between the states.

The health of individual state finances is fairly divergent. For instance, data from the RBI’s latest study on state finances shows that the fiscal deficit of states varied from a low of 1.6 percent of GDP in fiscal 2016 for Maharashtra to 5.2 percent of GDP for Goa. Foreign investors, however, tend to club all states together and see them as one asset category.

RBI’s Plan To Lure Foreign Investors Towards State Bonds Flops

To be sure, there are other more technical reasons as well. Among them, is the fact that most state governments tend to issue 10-year bonds while foreign investors prefer to invest in shorter tenor bonds. Low liquidity in the secondary market for state development loans also restricts interest.

Low liquidity compared to sovereign bonds inhibits easy entry-exit opportunities. On an average in secondary market, SDL volumes form 3-7 percent of total market volume while government securities volumes account for over 90 percent...Also while majority of state loans are issued in the 10-year bucket, foreign investors’ appetite is concentrated in the 3-year to 5-year bucket. Given that most SDL investors are in the buy-and-hold category, it is difficult for foreign investors to acquire sizable SDLs in the shorter maturity bucket.
Soumyajit Niyogi, Associate Director, India Ratings & Research