Bond-hungry FPIs continue to shun state loans

Foreign investors cannot seem to get enough of the bonds offered by the central government, but they do not seem to trust state governments much.

Foreign portfolio investors (FPIs) have exhausted 99 per cent of their investment limit of Rs 1.9 lakh crore in central government bonds, but when it comes to state government bonds, the share is less than 17 per cent of the permissible limit of Rs 30,000 crore, as of December 14. Bonds issued by state governments are also known as state-development loans (SDL).

According to the medium-term framework of the government, the limit for both central and state bonds will go up from January. As previous trends show, there is likely to be aggressive bidding to reserve the right for central government bonds, while state governments are likely to continue to get the cold shoulder.

This should be a cause for concern for the state governments, as their need for finance goes up every passing quarter. State governments collectively borrowed more than Rs 3.5 lakh crore in 2016-17 and their total borrowing is expected to cross Rs 4.5 lakh crore in the current fiscal year. This is higher than what the Centre used to borrow a few years ago.

According to JP Morgan, the consolidated state government expenditure is significantly higher than that of the Centre’s, and the state governments’ market borrowings are poised to overtake the Centre’s by 2018-19.

Not attracting FPIs as investors should be a damper for the state governments, but there are a couple of things going against the states.

According to a bond dealer who works for the local office of an FPI, most states lack transparency in their financial operations and looking at the stress incurred by them on account of paying up for state utilities, investors do not have confidence in investing in the bonds issued by the states.

“FPIs struggle to understand state finances and this is too much of a hassle when so many more easy investment ideas abound,” said the bond dealer.

The assessment is shared by others.

"The FPIs' muted interest in SDLs could be attributable to certain operational factors, such as, non-standardised way of presentation of state budgets, with some states reporting in only local languages, variation in the level of details shared, lack of easy access and timeliness of fiscal information,” said Aditi Nayar, principal economist of ICRA.

“From the FPIs’ point of view, such factors may act as impediments in gauging the risks involved in investment and may have deterred investment in SDLs,” Nayar said.

Additionally, concerns have emerged since the opening up of the first limit in October 2015, such as the impact of a takeover of discom debt under the UDAY scheme and the pay revision on the fiscal health of the states. These could also have led to reduced interest of FPIs in SDLs, she said.  

Saumyajit Niyogi, associate director of India Ratings and Research, said illiquidity in the secondary market for such paper was a major damper for investors.

“Most SDL issuance happens in the 10-year bracket, whereas FPIs like to invest in paper maturing in three to five years. When the market is illiquid, selling these bonds at times of need is very tough for FPIs,” said Niyogi.

Some FPIs will be interested in investing in SDL only if they carried an explicit guarantee from the Government of India.

The state development loans also suffer from opaque pricing. It does not matter which state is issuing the bonds, the spreads over equivalent maturity central government bonds remains more or less the same for all states, irrespective of the condition of their finances. The spread largely works out to be 60-80 basis points over the Centre’s bonds, and rarely crosses 100 basis points except when the states took over discom loans.

This was a kind of market distortion and prevented serious investors from getting into the space, said the bond dealer with the FPI. However, the RBI is trying to change that and has now proposed that a state’s coupon should be more market determined and be linked to the fiscal condition. This measure would help FPIs to sort riskier investments and should be well received by the market, said the bond dealer.

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