Photo: Mint
Photo: Mint

Masala bonds are no silver bullet

It is too early to conclude that they will have no downside risk, particularly if a huge amount of debt is issued suddenly

Recently, Indian banks were allowed to issue masala bonds. These bonds—internationally issued debt of Indian entities denominated in the Indian rupee—are often positioned as a panacea that will prevent India from committing the “Original Sin" of economics. As defined by economists Barry Eichengreen and Ricardo Hausmann, original sin refers to a country’s inability to issue debt securities denominated in its domestic currency in international markets.

In the last three decades, several sovereign crises were triggered because of various countries’ inability to service dollar or euro denominated debt. These developing nations were charged with this sin. The implication being that developing countries (a subset of which were elevated to the status of emerging nations) which do not have a track record of stable inflation and currency rate may only elicit sufficient interest in their debt if it is denominated in a reserve currency such as the US dollar, euro and the like.

In the Indian context, there is some merit in the masala bond move since Indian banks can do with some foreign investment and they will not face the foreign currency risk associated with foreign debt. But there are no unmixed blessings in real-life economics.

It is too early to conclude that such a move will have no downside risk, particularly if a huge amount of debt is issued suddenly. Among the things one needs to keep in mind while trying to avoid original sin is the fact that countries (Russia and Venezuela, 1998; Argentina, 2001) have defaulted in the past on domestic currency issuances as well. So domestic currency issuance per se does not guarantee reduction of sovereign credit risk.

Public sector banks’ (PSBs’) international credit rating draws explicit strength from India’s sovereign rating. For private banks’ credit rating, the dependence on India’s sovereign rating is more indirect. Thus, a masala bond issued by a public sector bank may be considered as a proxy on India’s sovereign credit. This aspect can have interesting ramifications.

Currently, international markets have limited ability to provide feedback on India’s risk and currency strength. This is provided in terms of buy-sell activity on Indian equities and restricted ownership of domestic debt. Till date, market instruments which connect more directly India’s sovereign risk with domestic interest rate and currency strength were virtually absent.

Masala bonds launched by PSBs may potentially provide the direct link. To the extent that these are quasi-sovereign issuances, their price is likely to be impacted by (a) fiscal deficit, a popular (but not comprehensive) proxy of India’s sovereign credit strength (b) domestic market interest rates which may be impacted by the currency-adjusted credit spread of masala bonds (c) domestic currency strength. The enhanced ability of markets to provide feedback on India’s market-perceived macro factors may add to the complexities facing Indian policymakers.

Indian policymakers have had an enviable reputation for defending the economy against external shocks since 1997—not that India can avoid the blame for sustained loose monetary policy or rampant fiscal profligacy. While an element of market-imposed discipline against fiscal and monetary profligacy is welcome, the importance of policymakers’ capacity for flexibility in handling an economic crisis cannot be underestimated. A case in point is the debate on whether stressed Eurozone members benefited from austerity which was perceived initially as market-imposed discipline against government spending.

Going forward, if government spending is urgently required or the interest rate needs to be cut significantly, the success of these moves would depend on how international investors perceive it and treat the domestic currency.

Among the most palpable signs of the government’s support of PSBs is the adequacy and timeliness of capital infusion. There is currently a broad range for the amount of equity capital required to be infused in public sector banks. To tackle this complexity, the government and the banks need to adopt higher levels of disclosure with respect to their quality of assets, so that markets don’t have to second-guess.

Still, in certain scenarios, policymakers may end up in a catch-22 situation. Say, the government is struggling to meet the fiscal deficit target, while as per the market, there is a need for infusion of a large amount of capital in government-owned banks. If the government then infuses capital in banks, the fiscal deficit situation may worsen, causing investors to treat public sector masala bonds, given their quasi-sovereign status, unkindly. On the other hand, if the government does not infuse capital in order to meet fiscal deficit targets, investors may take it as proof of insufficient government support and again hammer the masala bonds—which, if done on a large scale, can pump up the domestic market interest rate or weaken currency.

The long-term road map of the government’s ownership pattern of public sector banks needs to be developed and disclosed before large-scale issuance of masala bonds by public sector companies. This is essential because, in future, if the government stake is reduced significantly without much advance notice, the banks’ credit rating may get affected. The adverse price actions on a large number of public sector companies’ masala bonds may create a significant currency disturbance. In short, even well-meaning moves, if not disclosed in advance with detailed reasoning, may trigger disruptions. While masala bonds will reduce foreign currency risk, if not handled well, they may expose India to event risk which manifests as market volatility.

Deep Narayan is a financial services professional and visiting faculty at IIM Calcutta.

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