Does India Need A Sovereign Yield Curve?

Bankers and the government are divided on the issue even as companies increasingly raise money abroad.

Over the past year, as growing numbers of Indian companies turned their eyes to foreign borrowings, rumblings have been heard in the money markets about the need to establish a sovereign yield curve. The argument: a dollar-denominated yield curve could help Indian companies raise funds abroad at cheaper rates.

The demand has been strong enough to prompt the government to invite some foreign institutional investors (FIIs) to make presentations on this theme. FIIs have made a presentation to the government that it should float bond issues with varying maturities to establish a sovereign yield curve, Euan MacDonald, chairman, SBC Warburg India, told Business Standard last month. The finance ministry is now reportedly consulting the Reserve Bank of India (RBI) on the issue.

The notion is not radical. Many developing countries have sold sovereign securities abroad to establish a yield curve in overseas markets. The latest to join this race is Pakistan, which sold sovereign securities abroad two months ago with encouraging results. For a float of $100 million, it received tenders for $300 million at 395 points above the US treasury rate. This is considered a very fine rate, even for sovereign securities.

The sovereign rate is essentially a handy reference point that makes it easier for companies to price their paper abroad. It is similar to the yield curve established in domestic markets through government securities auctions. A sovereign yield curve also means Indian corporate paper will not be a new or unknown entity.

Usually, government debt flotations precede corporate bonds in overseas markets. So far, though, Indian companies raising debt abroad have been working in reverse. They have floated paper of varying maturities in Europe and the US despite the lack of a sovereign yield curve.

So in practice, the corporate yield curve has become a surrogate sovereign yield curve. Today, for instance, Reliance Industries 100-year bond has become a proxy of sorts for the sovereign yield curve. This is because investors are now familiar with the petrochem major which has raised nearly 1500 million dollars since 1992-93.

Given this, is there need for a sovereign yield curve at all? Yes, say some FIIs. Ajeya Singh, country head of Lehman Brothers South Asia, had pointed out in an interview last week that the government could have helped Indian companies save some 30 basis points in global flotations.

In the absence of any sovereign benchmark in the global debt market, the companies are forced to borrow debt funds at almost 30 basis points higher than what they actually could borrow at. The Indian government could help them save this higher cost by raising around $500 million to $ 1 billion and setting the sovereign benchmark, he said.

The sale of government securities abroad is different from that of corporate bonds in that sovereign bonds are usually regarded as low-risk, even nil-risk, securities. A sovereign government is not expected to default on its repayments, so international markets usually respond well to sovereign flotations.

When a corporate bond is issued in the absence of the sovereign yield curve, there is some confusion over its pricing. The market would not know how to react to the offer because it has no reference point. In such cases, it looks at countries and industries in a position similar to the offerer and arrives at acceptable pricing. There is no guarantee, however, that this pricing is efficient, either from the markets viewpoint or that of the issuer company. Usually, the yield on a corporate bond is a few notches above the sovereign yield, depending on investors risk perceptions.

FIIs do not think RILs 100-year bond is an adequate surrogate. They point out that if investor perception of RIL takes a turn for the worse, other companies could suffer in tandem. The chances of wide swings in investor perception of the sovereign yield curve are comparatively remote.

There are several views on how the government should go about establishing a sovereign yield curve. Some experts advocate the sale of securities with 50- and 100-year maturities, to cover a long time frame.

Tarun Saigal, head of fixed income trading and money markets at ANZ Grindlays, suggests that the government could wait for the country rating to go up before it takes a decision. The current credit rating of India is Baa3, indicating just above the investment grade status.

Another possibility, he says, is that the government would like to introduce capital account convertibility of the rupee before launching its securities abroad. Both should help improve the market for Indian sovereign paper.

Not everyone in financial markets, notably the RBI, are supporters of the sovereign yield curve theory. Some suggest that it is both unnecessary and could harm Indian companies. A senior RBI official points out that the cheaper funds available abroad will ultimately result in a larger fiscal deficit because government will be inclined to borrow these funds heavily.

This is because the international funds market attaches the lowest risk to sovereign bonds, so the cost of these funds would be much lower than in the domestic market. Sovereign borrowings will only encourage government profligacy and will ultimately pre-empt resources, he explains.

If the government tends to siphon off a large amount of resources from these markets, there will be little appetite left for the corporate paper. To prevent this possibility, he suggests that appropriate provisioning for such borrowings should be made in the budget, based on which the government may raise these resources. And since the current budget does not contain this provision, there is no need for the government to raise money abroad in the near future, he says.

Nor, he points out, does the government need such money at present as there is plenty of liquidity in the domestic market and the government can raise whatever money it needs locally and at fairly cheap rates.

Some FII representatives also point out that a sovereign yield curve may not help because sovereign securities abroad by other countries are of three year maturities. In contrast, Indian companies have already sold bonds for much longer periods. Sharing this doubt is Sanjiv Shah, senior vice president at DSP Merrill Lynch. Since the Indian corporate sector already has a large presence in overseas market, I am not sure whether the sovereign yield curve will have any additional utility, he says.

Another aspect of the establishment of the sovereign yield curve is that it will expose local financial markets to the world markets to a large degree. Although globalisation is very much a part of the process of economic liberalisation, an RBI official says the domestic economy could become prone to foreign influences to an unreasonable degree. The government will not be able to control the market like it is able to do now, he adds.

He gives examples of countries that have their foreign trade amounting to more than double their GDP. Countries like Hong Kong, Singapore, Netherlands and Belgium fall in this category. They have no way of restricting foreign influences on their economies, he explains. India on the other hand has much lower foreign trade and therefore is in an advantageous position to control foreign influences. Why should we throw away this advantage, he argues.

Fears have also been raised about the flight of capital. Given the appetite for emerging market securities, the initial response to sovereign securities is likely to be good. A small deterioration in the economy or the first hint of political instability could prompt lenders to withdraw their money, which could impair the governments ability to raise finance for itself.

Detractors of the sovereign yield curve also point out that this could make the government lose control over the monetary policy as exchange rates come under pressure because of the volatility emerging out of differing perceptions between domestic and foreign investors.

Nor can the curve guarantee that foreign money could continue to be cheap. When the foreign funds are converted in rupees, banks will have to hedge the funds. Considering that forward premia are in the range of eight per cent the actual cost may work out to 13 to 14 per cent. This is comparable to, and in some cases even costlier than, the rates at which government is able to raise resources domestically.

RBI officials suggest that the freedom given to foreign institutional investors to invest in government debt paper is enough to set up a sovereign yield curve in the domestic market. Overseas investors can always refer to this curve because the investment will land on Indian shores in any case. This, according to the RBI, is a much better option than the dollar-denominated curve because it is easier to control.

RBI officials also suggest that it does not make sense for the government to float debt paper abroad now given the current political uncertainty. Since international investors are sensitive to political changes, a dip in the sovereign yield curve could queer the pitch for the corporate sector.

This is what happened in Israel last year when the government was under pressure because of a sudden jump in inflation to 70 per cent. It had then to offer a yield of Libor plus 250 basis points on its securities in the international market - much higher than what it was offering earlier. This had a rub off effect on corporate bonds.

With arguments on both sides equally strong, North Block will have its work cut out deciding the issue. As a via media, an FII chief executive suggests evolving a synthetic domestic yield curve with forward rates superimposed. This should serve the domestic purpose as well as throw out adequate signals to the international markets.

Since the Indian corporate sector already has a large presence in overseas market, I am not sure whether the sovereign yield curve will have any additional utility.

Sanjiv Shah, senior vice president DSP Merrill Lynch

The government could wait for the country rating to go up before it takes a decision. It could also wait for capital account convertibility.

Tarun Saigal, head of fixed income trading and money markets at ANZ Grindlays