Mumbai: The draft guidelines allowing Indian companies to sell rupee bonds in overseas markets, released by the Reserve Bank of India (RBI) on Tuesday, may shift demand for funds away from banks, but could also help develop the credit default swaps (CDS) market in India, said bankers.

CDS is an instrument used to insure a lender from a loan default by the borrower. A bank “writes" the CDS and sells it to the bond investor.

In the overseas market, CDS are traded separately and were partly blamed for the credit crisis of 2008-09. In India, IDBI Bank Ltd was the first to write a CDS after the regulator allowed it in May 2011. This was followed by a handful of other banks but the product never took off in a big way. Trading is not permitted in CDS in India. As part of the draft norms for issue of rupee bonds in the global market, RBI said investors in these bonds can hedge both their foreign exchange risk and their credit risk in India.

While foreign exchange hedging instruments are well established in India, credit risk hedging through buying CDS protection is almost non-existent.

According to bankers, if investors in rupee bonds start to hedge credit risk in India as well, demand for instruments such as CDS will increase, helping the market develop.

“Certainly it could create interest in credit risk derivatives such as CDS. Foreign/trading banks will most likely want to write these CDS (sell protection) and there will be a new category of buyers for credit protection. Like any other market, it is essential to have two-way interest," said Manoj Rane, managing director and head of global markets and treasury at BNP Paribas India.

However, even as the central bank is indicating a push to CDS, there are practical impediments.

According to Harihar Krishnamurthy, head of treasury at First Rand Bank, the writer of CDS will have to set aside full provisions for the loan the bank has undertaken to insure. This locks in precious capital for the bank even as the fee generated through selling CDS may not be that high.

“If an Indian bank has to write CDS, they will have to charge a steep amount, which the foreign investors may find not very appealing," Krishnamurthy said.

Besides, there are complex documentation requirements between the CDS seller and the buyer, which banks often prefer to stay away from.

“Like any other market, it is essential to have two-way interest. RBI should now examine easing some of the non-standard documentary requirements (like separate master agreement, margining, etc.,), which could help activate the CDS market," Rane of BNP Paribas said.

Shifting demand for funds

The broader guidelines that allow firms to raise funds through rupee bonds may open up another avenue for funding for Indian companies and potentially take some demand away from banks.In Tuesday’s draft guidelines, the central bank proposed to allow companies to raise rupee funds selling bonds in overseas markets at a cost of up to 500 basis points (bps) above the equivalent maturity benchmark Indian government bond.

This opens up another avenue for Indian companies to raise funds, without getting exposed to the exchange rate fluctuation provided the companies get investors for their bonds

For example, the benchmark 5-year government bond yield is now 8.04%. A 500 bps spread above the benchmark means the issuer company can offer as high as 13.04% of coupon to lure overseas investors.

“Banks will have reasons to worry if Indian companies get access to the overseas market. Companies will not need to come to a bank if the rupee bonds really catch up in the overseas market. And it should catch up, because of the yields on offer and if the bonds are protected by CDS instruments in India," said a senior private sector banker who did not want to be named.

According to Krishnamurthy, by allowing companies to sell rupee bonds, RBI is simply enabling another avenue, which may end up being useful for top rated Indian companies.

“Overseas investors hardly invest in anything less than top rated bonds. And well-rated Indian firms can easily raise money from onshore bond market between 8.5-9%. They may opt for the overseas market only when rates are as fine as what IFC managed to raise at," Krishnamurthy said.

In November 2014, IFC (International Finance Corp.) raised $250 million equivalent through 10-year “masala bonds" at 6.45% and listed them on the London Stock Exchange. The draft norms do not lay down a rating criterion for firms using this instrument. “This shows RBI is a bit more relaxed about lower rated firms accessing alternative sources of finance so long as they are not exposed to foreign currency risk," said Rane.

Indian firms can access the global market to raise foreign currency through external commercial borrowing (ECB). However since the cost at which these funds are raised is restricted to 350 bps above London Interbank Offered Rate (Libor), only higher rated firms can access such funds.

To be sure, while the cost of funding through overseas rupee bonds is more relaxed than ECBs, other curbs, such as those on the end use of funds, remain in place.

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