InvestorQ : What will be the incentive for the foreign investors to take on the risk of rupee movements that have been quite erratic, in buying Masala Bonds?
Mary Joseph made post

What will be the incentive for the foreign investors to take on the risk of rupee movements that have been quite erratic, in buying Masala Bonds?

sara Kunju answered.
3 years ago

Masala bonds transfer the currency risk from the issuer to the borrower! But the question is why should investors take the currency risk in the first place? Most investors have been wary that the dollar rupee has been extremely volatile in the past and we have seen the value of the currency fluctuating wildly as we saw in 2008, 2013 and then again in 2018. The rupee movement versus the dollar on all these occasions were between 15% and 20% in a very short span of just two or three weeks.

Broadly, there could be two reasons for the preference to the Masala Bond despite the rupee risk in these bonds. Firstly, foreign investors are enticed by the higher rates of interest that Masala Bonds offer. In a world that is really stretched for alpha, even a few basis points higher yield is welcomed. If you look at the real interest rates on the Indian debt paper, it is not only higher than most of the developed markets debt but also higher than the emerging market debt. That brings us to the second risk of currency. Investors are betting that the INR will either be steady or appreciate from current levels versus the dollar. That means that investors in Masala bonds get a dual benefit. They benefit due to the higher comparative yields on Masala Bonds. Additionally, since these Bonds will be settled in dollars, the investor also stands to get more dollars for the same amount of rupees. But why are foreign investors so confident on the stability or relative strength of the INR.

Let us now see as to why be these foreign investors so confident about the INR being stable to strong versus the dollar? For a long time global investors preferred the safety of dollar denominated investments compared to bonds denominated in currencies of emerging markets. But a few key things have changed in the last few years that made these investors more positive on the INR. Firstly, unlike other emerging markets like Brazil, Russia, South Africa and Indonesia, India is predominantly an importer of commodities rather than an exporter of commodities. Hence the dividends of cheap oil and commodity prices could favour India. Secondly, the GDP growth advantage that India enjoys over China is likely to direct greater foreign portfolio investor (FPI) flows into India compared to other Asian emerging markets. Lastly, the more favourable business environment created by the current government as well as the “Make in Initiative” has made India a favoured FDI destination. In the last fiscal, India has already attracted more FDI than China. All these factors have contributed to the strength of the INR, as well as the confidence in the stability of the rupee.

Not surprisingly, the demand for Masala Bonds has been on the rise. Apart from higher yields, these Masala Bonds also offer the added advantage of a strong rupee to the investors. For the Indian issuers, this could save them the blushes of currency risk. This may just be the beginning of the emergence and acceptance of Masala Bonds and Indian currency bonds. However, the risk cannot be ignored. For example, one of the first misuses of these Masala bonds was discovered by the RBI wherein Indian companies were using the Masala Bonds route to have their global offices invest in these bonds and therefore the Masala Bonds were becoming a route for round tripping of funds. The approvals have dried up for now and may require tighter regulation and oversight from the RBI before the product can really take off in a big way.