November 14, 2010 9:55 am

India’s new bond rules to build on foreign interest

It is not often that India’s stock market becomes so hot that the country’s normally conservative Ministry of Finance jumps onto the bandwagon.

But in recent weeks, seeing near record foreign buying of Indian shares, the government has sought to grab a piece of the action through regulatory changes that it hopes will bring longer lasting benefits from these inflows.

In a policy that runs counter to other emerging markets, many of which are trying to curb inflows of overseas capital, India’s Ministry of Finance last month issued an order doubling to $10bn the amount that foreign institutions can invest in government treasuries. It also increased the amount international mutual funds can place in Indian corporate bonds by $5bn to $20bn.

“The policy has been reviewed in the context of India’s . . . increasing attractiveness as an investment destination and the need for additional financial resources for India’s infrastructure sector,” the Ministry of Finance said, announcing the measures.

Indian stocks have benefited from a record $24.8bn of foreign institutional inflows into the stock market between January 1 and November 2. The buying has driven the benchmark Sensex index up 16.5 per cent this year, making it one of the best performing markets in Asia.

The interest in India’s market was underlined by last month’s initial public offering of Coal India, the state-owned miner. The deal, India’s largest listing, attracted bids worth 15 times the $3.4bn of shares on offer. It will be followed by other large share offerings by government-controlled companies, such as Indian Oil.

“The interest in Indian IPOs is being driven by liquidity and a search for yields,” says Saket Misra, managing director at Royal Bank of Scotland.

The surge in volumes stems from greater liquidity in western markets, where central banks are looking to further loosen monetary policy to prevent their economies from slipping back into recession. Flush with cash, global fund houses are looking for investment destinations and, for many, India seems an obvious choice. The country’s gross domestic product is expected to grow more than 8.5 per cent in the fiscal year ended March compared with 7.4 per cent the previous year.

India’s economy is driven by domestic consumption rather than exports so it is better insulated from the impact of exchange rate appreciation that is dogging other high-growth emerging markets, say fund managers. “We are a safe haven investment story with a domestic consumption demand engine – the only one of its kind in the Brics,” says Jaideep Bhattacharya, chief marketing officer of UTI Asset Management in Mumbai.

India’s large current account deficit, at 4 per cent of GDP, means the country needs foreign fund inflows. While other developing countries are contemplating capital controls to try to prevent their currencies from appreciating, India is keen to draw
in more funding to help provide the finance it needs for investment in infrastructure and industrial capacity.

“It’s a mutually beneficial relationship,” says Nilesh Shah, deputy managing director of ICICI Prudential Asset Management in Mumbai. “India is a current account deficit country so it won’t put a cap on foreign institutional investor fund flows.”

Indians have traditionally been suspicious of foreign inflows after the country faced a balance of payments crisis in 1991. But Mr Shah says the country’s economic fundamentals have matured. Its foreign exchange reserves today are among the largest in the world and its people are also among the most prolific hoarders of gold.

India’s financial strength has led some to even argue that its economy and markets might finally be about to decouple from global trends. This impression has been boosted by consistently robust earnings growth from the corporate sector.

“We are now seeing a distinct breakaway in India’s interest rates and growth rates versus the rest of the world, notably the developed world,” wrote Ridham Desai, strategist with Morgan Stanley in Mumbai.

But he concedes that India’s dependence on foreign portfolio fund inflows for investment makes a complete decoupling difficult, leaving the country’s markets and capital-hungry companies to some extent still dependent on whims of western monetary policy.

“What seems more critical to us is the mix of capital flows, which are still skewed towards capital market sources rather than foreign direct investment,” says Mr Desai.

If India is to break this dependency, it will need to find ways to extract longer- term benefits from these foreign capital inflows. That is part of the rationale for the recent changes to rules covering investment in bonds introduced by the Ministry of Finance, says UTI’s Mr Bhattacharya.

“It will add depth to our bond markets, helping investment in the infrastructure sector and enabling the development of the government securities and corporate bond markets in India,” says Mr Bhattacharya of the changes.

If the measures do attract more inflows of funds into sectors such as infrastructure, the timing will be opportune. ICICI’s Mr Shah says some sectors of the Indian stock market, such as those dependent on domestic consumption, are looking expensive at about 25-28 times one-year forward earnings compared with 21-22 times earlier in the year. Infrastructure, however, has yet to take off in the same way.

“Our feeling is that now the country has to invest in infrastructure,” Mr Shah says.

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