FPI regime in India – recent changes relating to investment in corporate debt
April 2015 | PROFESSIONAL INSIGHT | BANKING & FINANCE
Financier Worldwide Magazine
The two different avenues through which Indian companies are able to directly raise debt from non-residents are either by availing of a foreign currency denominated borrowing under the external commercial borrowing (ECB) regime or through the issuance of rupee denominated bonds to Foreign Portfolio Investors (FPIs). Since both types of transactions are comprised of a capital account transaction between a resident and a non-resident, they fall within the ambit of the Reserve Bank of India (RBI), being the primary regulator in India for foreign exchange transactions. Since the FPI route consists of investment into the capital markets it is also regulated by the Securities and Exchange Board of India (SEBI), the primary capital market regulator in India.
The ECB route, contrasted with the FPI route, is far more restrictive. For instance, it is available only to certain eligible borrowers who can only borrow from certain recognised lenders, it stipulates restrictions on end use, it imposes a maximum cap on pricing of the debt and it also stipulates a minimum average maturity of three years.
The regulations which reflect the present FPI regime initially started with permitting foreign institutional investors and their sub-accounts (both of which were required to be registered with SEBI) to invest in rupee denominated non-convertible debentures (NCDs) and thereafter were broadened to introduce the concept of a qualified foreign investor (a non-resident investor who met certain basic eligibility criteria and who opened a beneficial owner account with a qualified depository participant). Subsequently, the two types of foreign investors have been collapsed into the FPI regime, under which different types of non-resident investors are divided into category 1, category 2 and category 3 investors on the basis of the perceived risk profile of each investor. The main difference in regulation vis-à-vis the categories is the extent of ‘know your customer’ checks required to be undertaken by the designated depository participants prior to the opening of beneficial owner accounts for each investor. One of the key objectives for the introduction and implementation of the FPI regime was to deepen the corporate bond market in India.
Prior to 3 February 2015, under the FPI regime, all categories of FPIs were free to invest in all types of rupee denominated NCDs which are listed or to be listed within 15 days of allotment of the NCDs (except in the case of infrastructure companies, where even unlisted NCDs can be subscribed to by FPIs) as well as commercial papers which are short term in nature (lasting one year or less). We understand that prior to 3 February 2015 there was significant FPI interest and activity in short term debt papers.
Through certain circulars issued on 3 February, the RBI and SEBI have amended the FPI regime to prohibit fresh investment by FPIs into corporate debt which has a residual maturity of less than three years. The governor of the RBI has stated that the purpose of this amendment was to align the regulations applicable to FPI into corporate debt with the regulations applicable to FPI into government securities (where such a restriction is present) and the measure was introduced as a means to nudge FPIs towards long term debt.
It appears that the rationale could be to ensure that all foreign exchange brought in by FPIs towards corporate debt continues to remain in the country for a longer tenure. Though practically the measure may have this impact (considering that the bond market is not very liquid and also that FPIs usually price their bonds slightly lower than domestic investors), this is belied by the fact that there is no restriction on FPIs selling the NCDs purchased to domestic investors at any time (assuming there is a willing buyer), and repatriating the foreign exchange received on such sale.
However, the circulars issued had certain lacunas which have been subsequently clarified by the RBI through the issuance of a circular setting out frequently asked questions. The RBI has clarified that fresh investment in commercial papers by FPIs would not be allowed. The RBI further explained that fresh investment by FPIs in a debt instrument with a minimum residual maturity period of three years, but with an option to sell such instrument prior to the expiry of the three year duration of residual maturity, would be prohibited. The RBI has also confirmed that FPIs would be allowed to invest in amortised debt instruments provided that the ‘duration’ of such instruments is three years and above. We understand that it is the intent of the RBI that the term ‘duration’, as used in this context, be considered to be a reference to the Macaulay duration of a bond, i.e., the measure of time taken to recover the initial investment in present value terms.
Some questions are still being discussed and debated among market participants, including: (i) whether the calculation of duration is to be applied even in the case of a non-principal amortised bond which has a residual maturity equal to or in excess of three years; and (ii) whether repayment of all amounts due to an FPI in respect of a bond on acceleration of the amounts due on the bond (e.g., on the occurrence of an event of default in terms of the bond documentation) would be permitted without the permission of the RBI.
The amendments to the FPI regime outlined above could impact several proposed transactions and may prove to be a dampener for those FPIs whose primary focus (vis-à-vis the Indian corporate debt market) has been investing in highly rated short term papers. It may also correspondingly impact issuers of such papers as they will not be able to raise short term papers at the same rates which were available to them immediately prior to the changes.
We understand that, considering that there are no time restrictions on FPIs selling bonds in the secondary market, certain impacted FPIs and issuers are exploring alternative structures which contemplate providing the FPI investors with an option to put the bonds to a third party at a predefined price on a predefined date. However, any such structure would need to be drafted bearing in mind the Securities Contracts (Regulation) Act, 1956 and the relevant notifications issued by SEBI. It remains to be seen how such structures would be viewed by regulators, and whether they would serve as genuine alternatives to investments in short term paper.
Gautam Ganjawala is a partner at Wadia Ghandy & Co. He can be contacted on +91 22 2271 5651 or by email: email@example.com.
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