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Kerala Infrastructure Investment Fund’s Masala Bond Issue Stirs Debate

Earlier this month, the Kerala Infrastructure Investment Fund Board raised Rs 2,150 crore through a masala bond issue. This issue of rupee-denominated bonds in the overseas markets was the first time a state government entity borrowed offshore, said a statement from Cyril Amarchand Mangaldas, which advised the entity on the issue of these securities.

While KIIFB had secured approval from the Reserve Bank of India before proceeding with the bond issue, it’s fund raising has raised questions. Among them:

  • If a state is not permitted to borrow overseas then should an entity guaranteed by the state be allowed to use that route?
  • Should this route become popular, will it lead to under-reporting of fiscal deficit by states as large infrastructure expenditure gets pushed on to quasi-government entities?

Permitted To Borrow, But...

KIIFB was set up as a body corporate, a statutory organisation set up by the Kerala legislature under the Kerala Infrastructure Investment Fund Act of 1999. It is essentially a state-owned organisation in charge of raising funds which are then used for infrastructure projects.

Harun Rashid Khan, former deputy governor of Reserve Bank of India, said that state governments cannot borrow directly in the overseas debt market. However, state government enterprises, that are registered, can now borrow via overseas bonds if they are eligible for foreign direct investment.

This change was made clear in the new External Commercial Borrowing (ECB) guidelines issued on Jan.16, 2019 by the RBI. The revised guidelines said that all entities eligible to receive FDI can borrow overseas.

“The RBI looks at the cash-flow, credit rating of the issuer and the viability of projects when state government entities apply for permission to borrow funds overseas. The regulator also looks at whether the borrowing entity is a surrogate for the state government,” said Khan.

In the case of KIIFB, the issue of masala bonds was guaranteed by the state government of Kerala. The notes “are unconditionally and irrevocably guaranteed by the Indian State of Kerala (BB/Stable) acting through the Finance Department of Kerala,” said Fitch Ratings in a rating note on the issue.

KIIFB also counts the Kerala chief minister as its chairman and the finance minister as its vice-chairman. It funds government projects and has no sources of revenue of its own.

Does the agency then qualify as a “surrogate” of the state government?

And if it is, does its offshore bond issue violate the provisions of Article 293 (1) of the constitution which says: Subject to the provisions of this article, the executive power of a State extends to borrowing within the territory of India upon the security of the Consolidated Fund of the State within such limits, if any, as may from time to time be fixed by the Legislature of such State by law and to the giving of guarantees within such limits, if any, as may be so fixed....

An email sent to the RBI on Monday evening was not answered.

T M Thomas Isaac, finance minister of Kerala and vice chairman of KIIFB told BloombergQuint that KIIFB received RBI permission before it went ahead with the Masala Bond issuance.

As a financial company which is part of the Government of Kerala, KIIFB has the right to raise overseas bonds so as long as the RBI gives permission.
T M Thomas Isaac, Finance Minister, Government of Kerala

Creating Contingent Liabilities

KIIFB’s masala bond issue may raise concerns beyond the technicalities as well.

Should other states follow suit and push borrowings on the balance sheet of state-level entities, could the fiscal deficit be understated? This concern is restricted not just to states but also extends to the central government.

M Govinda Rao, member of the Fourteenth Finance Commission and faculty member with the Takshashila Institute, explained that the Fiscal Responsibility and Budget Management Act sets a 3 percent limit on a state’s fiscal deficit. However, in the post-GST scenario, the fiscal flexibility of states has reduced.

“I think the Kerala Government is trying to use the space they have to the best of their availability,” Rao told BloombergQuint.

The problem today is that a significant part of state revenues goes towards paying interest expenses and social sector spending, so there is less money available for infrastructure. The FRBM Act does not allow governments to borrow more than the limit and under the Goods and Services Tax regime states can’t change tax policy and raise revenues easily. So, the only way to improve their revenues is through better administration.
M Govinda Rao, Member, Fourteenth Finance Commission

Rao added that borrowing off-balancesheet is a way of softening budget constraints.

“State governments have found ways and means of escaping these constraints and the bad practice of off-balance sheet borrowing actually comes from the central government,” he said.

Khan, however, felt that there are clear guidelines in place as the FRBM Act restricts the contingent liabilities of a state government at 1.5 percent of Gross State Domestic Product.

Albeit, they are not binding, he said.

Also read: CAG Questions Use Of Off-Budget Financing By Government

Will Other States Follow?

Should the RBI continue to hold the view that state-government guaranteed borrowings in the offshore market are permissible, other states may follow Kerala’s example.

“Other states can consider such a structure if they want to fund specific infrastructure projects and to that extent this is a very good beginning and it could go a long way in terms of raising funding for infrastructure,” said Jimmy Joseph, partner at Cyril Amarchand Mangaldas.

However, a state looking to tap this route may need to have an appropriate structure such as KIIFB that handles all infrastructure investments/projects, Joseph added. Investor demand for the KIIFB bond issue was strong and the state government guarantee helped demand and pricing of the issue, he added.

The Rs 2,150 crore issue carried a coupon rate of 9.73 percent.