Interest rates in the developed economies are still at very low levels, while investors are looking for high and stable returns for their money. This article outlines an innovative proposal for financing India’s infrastructure needs via government bonds targeted at foreign investors, with returns linked to the growth rates in the country.
Over the last ten years, India saw the best period in its history of economic growth, as well as one of the sharpest reversals of fortunes. Various global and domestic factors contributed to these events. However, by the looks of the present political and macroeconomic situation, the tide seems to be turning towards a slow but arguably steady recovery. India’s growth is inching up and inflation has been curbed to a large extent, largely owing to a fall in global commodity prices and high domestic interest rates. Although the country is not out of the woods yet as it still continues to suffer from twin deficits (fiscal and current account), there is no rating downgrade scare looming on it in the near term. The interest rates in the developed world are way below normal historical levels and the central banks are continuing to flood global markets with cheap money. The recent political stability in India is a welcome development for the long-term global investors that are flush with these funds.
Is there a way to take advantage of the situation? We see that on the one hand, there is a multitude of investors who have an appetite for higher and stable returns on their funds. On the other hand, there is a pressing need for rebuilding India in order to propel it to the next level of growth. India needs long-term finance for its smart cities, roads, bridges, airports, waterways, ports, and social infrastructure (health and education). It also needs a planned route to bring together domestic infrastructure demand and the external investors’ supply of funds. Many of these investors are indeed hungry to be a part of the growth story and developmental journey of an upcoming economic superpower.
Channelling foreign funds into India’s infrastructure needs
With this backdrop in mind, one may conceive an innovative idea of an ‘India 2025 Dream’, 10-year ‘Rupee-denominated’, ‘inflation protected’ structured bond issuance from the Government of India. The interesting structuring aspect will be in the way coupons (interests) are paid in this type of security. The annual coupon would be linked to India’s official Gross Domestic Product (GDP) real growth rate over and above a specified minimum rate, by a certain factor. Say, this minimum growth rate is 5%, actual annual real GDP growth rate is 8% and the factor is 1.5; in this case, the annual interest rate on the bond will be 5% + 1.5*(8% - 5%), as long as the difference between the actual and minimum growth rate is positive (meaning that actual growth is higher than specified, minimum growth). If actual growth rate is equal to or below the specified minimum growth rate, the annual interest rate on the bond will be 5%. The investment is made in rupees and the principal amount is paid back in rupees at maturity. The principal amount that is paid back takes into account the inflation during the period of the bond.
The issuance may be targeted to institutions like global investment funds, pension funds, banks and Non-Resident Indians (NRIs). Initial total size of the bond issuance could be around US$ 25-50 billion, which is still only a small part of the estimated trillion dollar infrastructure deficit in India. Further issuances could be done as and when funding needs arise, although the raised funds need not be tied to specific projects.
What’s in it for the government and foreign investors?
Through this relatively safe, fixed minimum income instrument, foreign investors would be able to take a bet on India’s growth story. While being protected from inflation, they can also speculate on a stronger rupee at the end of ten years as they will be paid back in rupees1. From the ‘bond issuer’ perspective, the Indian government will pay more in ´good´ years and less in ´difficult´ years, making it a flexible financing option. Moreover, the product adds no pressure on foreign exchange as the principal amount invested (as well as annual interest) is paid out in rupees2. The embedded options give an equity-like feature to the product through which investors have a chance to earn higher returns in a growth upside but face the risk of receiving an interest that is lower than that on regular government bonds with the same maturity. However the instrument has a downside cap (5% interest rate, in the example above) like any fixed income product, which is often required by longer-term investors especially in a developing market.
One of the challenges that the government could face is the increased scrutiny of its GDP data, in terms of accuracy and timeliness. While the government would not have any significant incentive either to understate or overstate the GDP figures on the back of this issuance, a product like this would require credibility of the government data among foreign investors.
Of course, the key factor for the success of such an investment product would hinge on appropriate use of funds by the government. The funds should be employed optimally in revenue-generating and productive infrastructure projects that boost India’s GDP in the long run; this would require a consensus among the various agencies and stakeholders within and outside of the government.
The article is based on personal views of the author.
1. Investors do face the risk of the rupee becoming weaker over the period of the bond, but the reasoning is that if the foreign investors buying the bond believe that the growth rate of the Indian economy will be high, they are also likely to have the view that the rupee will become stronger.
2. There may be pressure on the exchange rate if, at the end of the period of the bond when the principal investment is paid back, all foreign investors exchange the rupees for their own currency at the same time and don´t reinvest in any other financial instrument in India.