India's states to compete for foreign cash as bond market opens up

By Suvashree Choudhury and Himank Sharma

MUMBAI (Reuters) - India's states are gearing up to sell up to $7.6 billion in debt to foreign investors for the first time, stepping up competition for funds that could force the country's spendthrift provinces to clean up their books and tighten spending controls.

India's states pay the second-highest government yields in Asian emerging markets after Indonesia: around 8.16 percent for a 10-year bond, much higher than central government debt and nearly two and three times the yield on Philippines and Thai paper.

That is expected to be a big draw for overseas funds, which have already poured nearly $8 billion into Indian central government debt so far this year, attracted to economic fundamentals that have been relatively better than emerging market peers.

The arrival of foreigners could force a major change in the state government bond market, where yields vary little across the states despite different fiscal positions, and put governments under pressure to curb wasteful spending.

Some states are prone to expensive pre-election giveaways: everything from spice grinders and fans to laptops and subsidised or free rice and vegetables.

The Reserve Bank of India (RBI) has told investors that all states benefit from identical sovereign guarantees. But foreign investors, unlike domestic investors who tend to treat state debt equally, say some states will be more appealing than others, at least in the short term.

"There are so many states in India and each state is pretty much a country of its own," said Leong Lin Jing, a Singapore-based investment manager on Aberdeen Asset Management's Asian local rates and currency team.

Jing said clarity was needed on what the implicit sovereign guarantee meant in practical terms and on the ability of state governments to borrow from the central bank.

The RBI said last month it would progressively open up state-level debt, allowing foreign investors to invest up to 500 billion rupees ($7.6 billion) through March 2018. Auctions are set to start on Monday.

The ensuing pressure to clean up state finances comes at a time when the Indian government is devolving far more funds and spending decisions to the states than ever before.

MOMENT OF TRUTH

India is composed of 29 states of sharp contrasts, varying from poor states such as West Bengal, seen as spendthrift, to wealthier ones such as Maharashtra, home of financial capital Mumbai and with an economy roughly the size of Egypt.

So far domestic investors have seldom differentiated between fiscally stronger states and weaker ones, comforted by the assurances of the implicit sovereign guarantee. No state has ever defaulted to actually test that commitment.

Gujarat state, rated at "A plus", paid 8.15 percent for 10-year debt at the latest auction. Meanwhile, "BBB plus"-rated West Bengal, which is three notches below, paid 8.17 percent.

"It's imperative that we look at each state differently," said an investment adviser with a London-based debt fund.

States are facing a critical test of their fiscal discipline as India's government hands out more financial power, giving more than two-fifths of federal revenues back this year, compared to one-third previously.

Prime Minister Narendra Modi has also been urging states to take a lead role in attracting investments and accelerating the economic recovery.

"We will monitor the pricing from foreign investors," said Arvind Srivastava, secretary of budget and resources at Karnataka state, home to outsourcing centre Bangalore.

"We are ready to take corrective actions to bring down borrowing costs if there is any price differentiation made."

(Editing by Rafael Nam and Mark Bendeich)