Improving the Regulatory Framework Governing Masala Bonds

[The
following post is contributed by Dhanush.
M
, a 5th year student at the Jindal Global Law School]
“Masala bonds” refers
to rupee denominated bonds issued in offshore capital markets which would be
offered and settled in US dollars to raise Indian rupees from international
investors for infrastructure financing in India. Masala bonds could prove to be
a viable source of corporate finance as they shift the exchange rate risk to
investors. Masala bonds also serve the policy objectives of the Reserve Bank of
India (RBI) of integration of the Indian economy into the global economic
system and internationalisation of the Indian rupee.
The `Draft
framework on issuance Rupee linked Bonds Overseas
` issued by the RBI
links
the issuance of masala bonds to existing regulations governing external
commercial borrowings (ECBs).
 Investors in these bonds will be eligible to
hedge both the foreign currency risk as well as credit risk through permitted
derivative products in the domestic market. Investors can also access the
domestic market through branches of Indian banks abroad or branches of foreign
banks with Indian presence.
In addition, borrowings of three to
five years have a price cap of 350 basis points over six-month Libor and those
of more than five years have a price cap of 500 basis points over six-month
Libor.
Banks incorporated in India will not have access
to these bonds in any manner whatsoever.
The treatment of Masala bonds through the ECB regulations
restricts the growth of the market quantitatively in relation to the maximum
amount of money a firm is eligible to borrow externally, and qualitatively in
relation to the end-use, tenure, maturity 
and all-in-cost ceiling restrictions. The recommendations made by the
Sahoo
committee
suggested that ECB restrictions of end-use,
maturity, tenure and all-in-cost ceiling do not have nexus to the stated
objectives of addressing market failures. In other words, the ECB restrictions
should be abolished.
ECB access should only be denied to
sectors where FDI is banned, such as gambling, lottery, chit funds, real estate
or construction of farm houses and manufacturing of tobacco products
. Alternatively,
to regulate foreign currency inflows into India, the existing guidelines on
foreign ownership of Indian companies would suffice.
In the case of Masala bonds, since the exchange
rate risk is shifted to the foreign investor, the investor typically hedges its
investment through currency and credit derivatives. Therefore, it is important

that the strength of the currency derivatives market be improved through the
introduction of more instruments, widening the base of the participants through
commensurate regulations along with modern risk management systems and improved
customer service.
Additionally, there is a need to increase liquidity
in long-term hedging products. Development of markets for long-term hedging
products is necessary to reduce risk in the system. Use of most advanced
payment and settlement infrastructure in the forex market is required along
with improvement in other market infrastructure.
Also, the cost of hedging should be
optimised to the investors so that the gains from interest on bonds are not
frittered away in derivative transactions, such that subscribing to masala
bonds becomes financially unviable. The cost of hedging would be reasonable
only if there is a deep and liquid well-functioning onshore currency
derivatives market. To develop a liquid secondary market for Masala bonds,
there is need for a benchmark yield curve across maturities because lack of
pricing in the secondary market is not observable across maturities which has
an enormous impact on liquidity.
With regard to the use of options
as a hedging instrument, while there is increasing interest amongst end-users
in using currency options, not many banks in India have scaled up their
expertise in this area and the option activity remains confined to just a few
banks. This prevents the development of an active options market. It is
necessary that banks enhance the relevant skill-sets in this product which have
been strongly favoured by investors.
As for the market for credit
derivatives, there is a need for expansion of the list of market participants
and the list of debt instruments on which credit default swaps (CDS) can be
written. Also, the liquidity of the currency underlying in India needs to be
strengthened.  It is important to expand
the scope of the currency derivatives market by including unlisted corporate
bonds as users of CDS and one should allow CDS on unrated bonds and loans.
Furthermore, there is a need for clarity on tax
treatment of Masala bonds. In RBI’s
draft framework
, there was no mention of the tax treatment on Masala bonds,
as a decision on this can be taken only by the revenue department.

Currently,
there is a withholding tax for foreign institutional investors of five per cent
for in ECBs, as well as in domestic corporate bonds. If companies seek raise
capital through this platform without clarity on the taxation aspects, they
would end up paying a higher coupon rate, due to which it might become
financially unviable. Ideally, it may be worthwhile to award exemption to
foreign investors from withholding tax to incentivize their participation in
masala bonds.

As per existing regulations, a long
term equity share held for more than one year and on which securities
transaction tax (STT) is paid  would be
exempt from tax (Section 10(38) of the Income tax act, 1961). A similar
provision could be extended to Masala bonds.
It would be very beneficial to the
masala bond market if the fixed cap on coupon rate is removed gradually over a
period of time as fundraising by high yield issuance would be difficult for
small and medium scale companies who stand to benefit the most from a vibrant
masala bond market.
I conclude stating that the
aforementioned recommendations would be positive changes to the Masala bond
market.  However, the changes have to be
coupled with positive steps to improve on the institutional shortcomings like
the bankruptcy code, creditor rights, clearing and settlement agencies that
could impede the growth of the Masala bond market.
– Dhanush. M

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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