Currently, FPIs are allowed only in government securities (G-sec) and corporate bonds with limits of $30 billion and $50 billion respectively.
Explaining the rationale, RBI Governor Dr Raghuram Rajan in a chat with Business Today said that some of the states with strong fiscal position should also benefit from having variety of investors, who can contribute to bringing down the interest cost. Today, the major investors are domestic institutions, commercial banks, mutual funds and insurance companies. In fact, these institutional investors also have limitations in investing in state bonds because of the precarious position of many of the states. "So obviously, the FPI will be discerning and make judgment about where (which states) they want to go. It's a market that is developing," says Rajan.
Clearly, in the longer run, the FPI in state bonds would help increase the investors base, create more liquidity and also benefit in bringing down the cost of funds. A good example is the corporate bond market, where FPIs are gradually taking interest. In the last few months, many FPIs switched to corporate bond market when the limit of $30 billion was breached for G-Sec.
The RBI has carved out a special limit for state development bonds, which is over and above the $30 billion limit. The plan is to open the investment in phases, which would eventually be just 2 per cent of the total rupee denominated state bond outstanding by March 2018. This translates into bonds worth Rs 50,000 crore in the next three years. In the current fiscal, bonds worth Rs 7,000 crore would be available for FPI.
Expert suggest that it is just a beginning as India anyways is very cautious in allowing the foreign investment in Indian debt market. Any external debt has implication on currency value. The East Asian currency crisis is a good reminder, where the exit of many of the foreign investment in equity and debt severely impacted the currencies of the investee nation. Even the size of the SDL is not big as compared to central government's G-Sec plan. In 2014-15 , the state bonds issuance was pegged at Rs 2.07 lakh crore, a large part of which were issued by states not very strong fiscally.
"The difficult part for FPI would be the selection of states for investment," says Sunil Sinha, Principal Economist and Director at India Ratings & Research. Any investment in debt market has to have a reference (rating) to take a call. In case of domestic institutional investors like banks, they have a reasonable idea of different states whereas investors in US and Europe would look for much more information or rating to take a call on state bonds.
There is also a danger of foreign money getting concentrated into few good states like Delhi, Gujarat, Karnataka, Maharashtra etc, which are anyway in good shape fiscally."What we need is greater fund flow into states like Bihar," says a banker.