RBI to draw the line for FII play in corp bonds

NEW DELHI/MUMBAI: The finance ministry has assigned the Reserve Bank of India (RBI) the task of framing a comprehensive policy on investment in domestic corporate bonds by foreign institutional investors (FIIs).

This has been done considering the overall implications of this issue on interest rate management in the country, according to officials.

“There are larger policy implications and it is outside Sebi’s domain,� said a senior finance ministry official. The recent handling of the issue by the Securities and Exchange Board of India (Sebi) has triggered the move to allow RBI to take a broad look at the ceiling on FII investment in domestic debt, said officials.

Following Sebi’s move to impose a ceiling of $500m on FII buying in corporate bonds on Thursday, corporate bond yields moved up, while the spread between government securities and top-rated corporate paper widened.

Earlier, the spread between the two had narrowed considerably. The short bout of volatility on Thursday was sparked off after what the market perceived was a reversal of a key government decision.

On Tuesday, the government had said that buying of corporate debt by FIIs would be outside the annual ceiling of $1.75bn. But it did not specify a ceiling up to which FIIs can buy corporate papers.

The announcement prompted FIIs and foreign banks (who have FII affiliates in India) to pick up huge amounts of corporate paper. FIIs and banks, acting on their behalf, bought around $1bn worth of corporate bonds from the primary market.

Exclusion of corporate debt from the overall cap of $1.75bn had prompted domestic borrowers to float bond issues targeted at FIIs, who were keen to pick up papers after the government relaxed rules.

These issues were primarily from financial intermediaries such as HDFC, Exim Bank and Nabard. Foreign banks bought the papers to make a gain by selling these to FIIs.

In FY04, when the rupee was appreciating, FIIs showed great interest in picking up corporate paper. However, the then cumulative ceiling of $1bn for buying local bonds was a deterrent.

Considering this pent-up demand, Sebi requested the government to raise the ceiling. The finance ministry and the RBI did not relent as they were of the view that further opening up of the bond market to FIIs would have repercussions on the macro-economic front.

This was the phase when RBI was battling huge capital inflows, which were affecting money supply and inflation. Credit pick-up was sluggish and corporates were keen on accessing cheaper overseas debt, instead of contracting loans from domestic sources.

Sebi''s request for a higher FII ceiling was then rejected, as according to a senior government official, “What is in the interest of corporates may not be in the interest of macro-economic management.�

There were also concerns that FIIs’ large appetite for local debt reflected short-term arbitrage opportunities. A strong rupee ensured that FIIs could hope to earn good returns by investing in top-rated corporate bonds for short maturities at very little risk.

Officials feel the same argument holds true if the top-rated corporates were to raise money at attractive rates by placing debt with FIIs. This, they feel, would have implications for local banks, which would have to settle for second-rung companies to provide credit.

In the past few days, the government and regulatory agencies did not seem to have anticipated the rush to pick up corporate paper. Whatever has been done on the policy front over the past couple of days is seen as only an interim arrangement until a comprehensive policy is firmed up.

The decision to impose a ceiling on investment in corporate bonds, after the government granted a significant relaxation to FIIs, has not gone down too well with foreign banks. They are saddled with huge amounts of corporate debt, which they were earlier hoping to sell to FIIs.

With the market remaining cautious on interest rates, bankers feel that the ability of foreign banks to find buyers for the papers may be severely constrained. However, dealers feel that banks would be able to sell these papers over a period of time, provided sentiment improves in the market.