Fitch: Indian NBFIs to Raise Masala Issuance to Support Growth

Indian non-bank financial institutions (NBFIs) are likely to become more active issuers of masala bonds over the medium term, reflecting their rising need for diversified funding to support growth, says Fitch Ratings. Improving recognition of the masala bond market among international investors could help to improve relative pricing, but only larger NBFIs with strong reputations are likely to find masala issuance viable.

NBFI credit grew by 13% in 2017, around 4x faster than bank credit, while the share of total credit extended by financial institutions rose to around 21% in FY17, from 17% in 2014, according to our estimates. NBFIs are likely to continue to play an increasingly important role in India's economy over the next few years, helping to compensate for weak bank lending, which is likely to be held back by state banks' undercapitalisation, despite the government's planned injections. NBFIs will also continue to provide an alternative source of credit to the large proportion of Indian borrowers that are underserved by banks.

NBFIs will require funding to support growth, and we expect banks' share of funding to fall, given banks' capital constraints. NBFIs have already shifted towards bond market funding in recent years, as yields have fallen while bank lending rates have remained stubbornly high. Masala bonds - rupee-denominated bonds issued in offshore capital markets - potentially offer issuers a larger investment pool, while avoiding the currency mismatches associated with international bond issuances denominated in foreign currency.

Pricing remains an obstacle - issuers have so far typically faced yields 20-50bp higher on masala bonds than domestic issuance. International investors' risk aversion towards Indian issuers and concerns over currency risks could mean this remains the case.

However, the pricing mismatch between masala and domestic bonds may fade as the masala market deepens and international investor recognition improves. Indeed, yields on Shriram Transport Finance Company's masala bonds issued in March 2018 were lower than those on its comparable domestic bonds, as per issuer feedback. There were USD7 billion in masala bonds outstanding at end-September 2017, according to press reports, indicating reasonable activity since the first issuance in 2016. Rising domestic interest rates may also serve to narrow the pricing gap, if yields on domestic bonds respond more sensitively than masala yields. The 10-year government bond yield has increased by more than 100bp in the last 12 months, and we expect the Reserve Bank of India to hike its policy rate by 75bp over the next two years.

Even as market recognition improves, smaller unrated issuers are still likely to find masala issuance difficult. Some issuers have previously issued masala bonds on an unrated basis, but these have all been marquee names and at tenors of less than three years. Issuers are increasingly looking at longer tenor borrowing, for which reasonable standalone creditworthiness is likely to be a prerequisite.

NBFIs have had a challenging two years, as migration to a 90-day NPL recognition norm, from a 180-day norm, led to a sharp rise in NPL ratios and credit costs. The operating environment was also made difficult by slowing GDP growth and challenges associated with demonetisation and implementation of the goods and services tax. Nevertheless, credit growth remained in double digits and sector ROA stayed relatively healthy at around 1.6% in FY17, with most large asset finance companies reporting ROA well above 2%. Low funding costs and aggressive cost-cutting helped to partly offset the impact of higher credit costs. Capital positions have also been kept largely stable. Asset quality pressures are likely to ease following the completion of the NPL recognition transition at end-March 2018, which should support margins and growth.

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