HDFC takes leadership role in masala bonds

This week HDFC would become the first Indian public issuer of masala bonds, rupee-denominated bonds issued in the offshore debt market.

The Bonds will bear a fixed coupon and will have a tenure of 3 years and 1 month. The Corporation proposes to list the Notes on the London Stock Exchange. Pricing will take place on or before Friday , July 15, 2016, subject to market conditions.

In financial terms, masala bonds are a copy of China’s dim sum bonds — bonds denominated in a currency other than United States dollars — in this case, Chinese yuan. The whole process of issuing masala bonds was formalized by the International Finance Corporation (IFC) in 2013, with the approval of the Indian government then in power.

HDFC’s current masala bonds issue still needs approval from India’s central bank, the Reserve Bank of India (RBI) because foreigners cannot legally hold Indian rupees, and anyway don’t want to hold Indian rupees. The RBI recently made a key change in its rules for masala bonds — allowing borrowing for a minimum of 3 years instead of a minimum of 5 years. (HDFC’s loan period is 3 years plus 1 month.)

So masala bonds work this way, forgetting the interest rate for the moment:

1. HDFC borrows $1 million dollars and takes it to RBI.
2. RBI converts it to ₹70 crores, using ₹70 = $1 as the exchange rate.
3. HDFC lends ₹70 crores in India.
4. At the end of 3 years, HDFC takes ₹70 crores to RBI, and asks it to convert to US dollars.
5. If the exchange rate has changed to, for example, ₹80 = $1, then RBI will give not $1 million, but only about $0.9 million.
6. HDFC will return not $1 million but only $ 0.9 million to the original foreign lenders.
7. The foreign lenders would have lost some money — it is for this fear that they want a high interest rate.

The interest rate offered by HDFC to foreign lenders thus remains a major unknown at the moment.

By comparison, last month HDFC sold three-year bonds in India carrying a rate of 8.46%. While the cost of raising money through the masala bonds will be slightly higher, HDFC will get the benefit of diversifying its source of funds. In other words, borrowing from foreigners will not be cheaper than borrowing from Indians. But the recent drop in interest rates abroad has made HDFC go ahead, even willing to pay slightly more just to diversify the borrowing options.

If the new RBI governor lowers interest rates in India, then masala bonds may look less attractive. If HDFC is forced to pay an interest rate higher than domestic rates, then a fundamental problem remains — there is a gap between what Indians want to pay and what foreigner lenders want to earn. So, home loans for Indians, for example, will not get any cheaper.

Also, if the new RBI governor indicates that the rupee will slide down, that would also be a negative for future masala bonds.

There are still many Ifs — no one knows what will happen because there are too many factors at work. The only thing that appears to be clear is that HDFC is willing to pay a higher interest to borrow abroad than it pays in India.

HDFC’s plan is to borrow ₹2,000 crore, with an option to increase it to ₹3,000 crore if there are many people interested in lending to HDFC— a small amount compared to the ₹50,000 crores it is planning to borrow in India this year. Of course, the actual interest rate is not yet known —and cannot be known until HDFC actually does the transaction. HDFC can take the risk — and even if the interest rate is 9%, it will be OK.

So far it appears that HDFC knows what it is doing. If it succeeds, it will represent a breakthrough in India’s efforts to internationalize the rupee. It will also promote competition in financial markets among foreign lenders to disburse corporate loans to Indian companies. Overall, a very good idea.