With burgeoning flows on the current account and the capital account - with gross flows that exceed 90% of GDP and are growing much faster than GDP - the internationalisation of the INR is inevitable. I have previously written about how wrong India's approach on capital controls is, with rules that limit INR denominated borrowing but encourage foreign currency borrowing. It reminds me of pre-crisis South Korea, which encouraged short-dated debt flows but blocked equity flows.
A remarkable development has taken place for the INR: The first INR denominated offshore bond has come about, far from the clutches of local capital controls. This sets a new frontier for what you can do with the INR NDF market. Inter-American Development Bank has raised Rs.1 billion ($23 million) with an INR-denominated bond. The most interesting feature of the situation is what RBI proposes to do about this -- introduce more capital controls (see text which is not in italics). This text is from IFRAsia ($$) on 3 February 2007:
Non-deliverable forwards drive first offshore rupee bonds International investors recently had their first opportunity to gain exposure to the Indian rupee fixed-income market without having to register with the Reserve Bank of India thanks to the first ever non-deliverable Indian rupee-denominated bond.
The February 2010 bond, which was arranged by TD Securities, might have been small - it raised Rs1bn (US$23m) for the Inter-American Development Bank (IADB) - but it seems likely to be a taste of things to come.
"Through this structure, we are providing non-Indian entities access to rupee bond issuance and offshore investors a way to express a position in Indian rupees," said Greg Moore, a director with TD Securities in London. "The deal was small in size to start with but as investor confidence grows, we expect it to be upsized."
Though the deal was the first of its kind in rupees, TD has also arranged similar transactions for other issuers in Brazilian real or Indonesian rupiah.
The bonds, which are listed in London, pay an annualised coupon of 7.25% which is inside where Indian government bonds trade - possibly one of the motivations for the trade. Though denominated in rupees, the IADB deal is settled in US dollars. Seven investors based in Belgium, Canada, Germany, Switzerland and the UK bought the bonds.
Foreign investor interest towards rupee debt has been rising over the past few years but restrictive local regulations mean that it is difficult for most investors to access the market. The Indian rupee is convertible on the current account but not fully on the capital account which means that offshore investors looking to take rupee exposure cannot do so offshore and have to register as foreign institutional investors and then invest in India.
The total amount of foreign investment in rupee bonds is, however, tightly controlled and many investors don't bother to register as they will struggle to get access to enough rupee paper to make it worth their while.
Taken together, foreigners are now allowed to hold US$2.6bn in government bonds, with that limit due to rise to US$3.2bn by the end of March. The limit for corporate debt is US$1.5bn.
Regulators have been wary of inviting large-scale foreign investment in debt (unlike in equities) amid worries that this would encourage large speculative flows that could pose a systemic risk. But it is clear that the lack of foreign participation is one reason for the domestic market's lack of depth.
The IADB transaction skirts these issues by using non-deliverable forwards which, while based on rupees, don't directly interact with the onshore market. The NDF market gives offshore players a synthetic exposure to the currency and trade settlement is in foreign currencies based on the movement in the rupee versus foreign currencies.
However, the RBI is even looking to curb the progress of this market. In November, the central bank issued draft guidelines on the use of derivatives in India which will supersede all existing guidelines when they are confirmed.
One proposed rule states that market-makers and users should "not undertake any derivative transaction involving the rupee that partially or fully offsets a similar but opposite risk position undertaken by their subsidiaries/branches/group entities at offshore location(s)". In other words, the RBI is attempting to stop banks offering offshore-based rupee product from offsetting risk in the onshore market. If it is able to do that - a big "if" given that enforcement would be very difficult - such transactions would become considerably less efficient for the banks arranging them.
Either way, bankers think that there is very little the RBI can do to stop deals like the one from the IADB. News last week that S&P has also upgraded the Indian sovereign to investment grade is likely to add to the demand for such deals and make it worthwhile for banks to put in the work needed to construct such transactions.
"The biggest challenge of doing such deals is piecing the various inputs inherent to this type of trade together. But given the strong interest evidenced by investors, we expect more such deals in the future," said Moore.
Update: Jayanth Varma has written about this on his blog.