Kerala govt is in the dock over 'Masala bonds'. What are they anyway?

The Kerala Infrastructure Investment Fund Board (KIIFB) has been in the news of late as the Enforcement Directorate (ED) has started an investigation into its masala bonds issued to raise funds. 

The ED, which looks into economic offences in the country, has sought details from the Reserve Bank of India (RBI) about the fund-raising on the basis of a report of the Comptroller and Auditor General of India (CAG), which has said that KIIFB caused a liability of Rs 3,100 crore to the exchequer through the ‘masala bonds’. 

But what exactly are ‘masala bonds’ and why has CAG questioned KIIFB’s decision to issue them? 

What is ‘Masala Bond’?

Masala bonds are bonds issued outside India but denominated in Indian rupees instead of the normally preferred US dollar. The term ‘Masala bond’ was first used by the International Finance Corporation (IFC) to enable a “cultural connect” with India. 

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In dollar-denominated bonds, the borrower (the party issuing the bonds to raise the money) takes the currency risk (ie, the change in the value of the dollar affecting the interest to be paid), but in ‘Masala bonds’, the investors bear that risk (their returns are affected by the change in the value of the currency vis-a-vis the dollar). 

Simply put, a ‘Masala bond’ is a rupee-denominated bond issued to overseas investors and is settled in US dollars and is subject to the financial regulations of the respective jurisdiction.

The first ‘Masala bond’ was issued by the World Bank-backed IFC in November 2014 when it raised Rs 1,000 crore to fund long-term infrastructure projects in India. Later, in August 2015, the IFC for the first time issued green masala bonds and raised Rs 315 crore. The proceeds of the bond was to be towards investments that address climate change in India. 

When ‘Masala bonds’ were first issued in 2014, the then finance minister Arun Jaitley had said $1.5 trillion was needed in infrastructure spending over the next decade. The need for innovative financial instruments such as the ‘Masala bonds’ was a central piece of the public finance strategy to enable this ambitious infrastructure push and the Narendra Modi government reinforced this approach when it later issued policy tweaks that included reducing the withholding tax on the interest income from 20 per cent to 5 per cent. 

The Communist government in Kerala also wanted to leverage the global financial markets with innovative financial instruments to finance infrastructure spending through KIIFB. 

The Kerala offering 

After the Lok Sabha election phase in Kerala was complete on April 23, 2019, the state government shifted attention to more pressing tasks concerning the state of public finance. A team headed by chief minister  Pinaryai Vijayan landed at Canary Wharf to finalise the first-of-its-kind bond offering from India.

By issuing the‘Masala bonds’ to raise Rs 2,150 crore, KIIFB became the first sub-sovereign entity in India to tap investors in the offshore rupee international bond market. The bond was listed on the London Stock exchange on May 17, 2019. The returns on this bond were considered  attractive given the benchmark rate than was prevailing then.

The fund raised through the KIIFB masala bond was used for Kerala’s several ongoing infrastructure development activities, including KFon, Petrochemical and Pharma Park-Kochi.

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The speciality in the case of this bond was the securitisation aspect of it, with monies coming from future revenue of motor vehicles tax and fuel cess directly linked to the proceeds. The transparency followed by the issuer had an encouraging response from investors including global pension funds. 

The fundraising, however, has had its critics who have said the Kerala government is paying a high “price” when compared with other ‘Masala bonds’ being listed from India with much lower yields. But experts point out that raising funds is not just about pricing alone and that for an institution like KIIFB, an entry into the international financial market could throw up a lot of opportunities in the long run.

CAG’s objection

CAG has said the ‘Masala bonds’ could result in a loss to the state exchequer, 

The problem with CAG’s methodology of calculation is that it is similar to the one it had used to calculate the loss in the case of 2G. The deemed liability (notional loss) is being calculated based on actual future proceeds instead of the normal method used in public finance, which is to discount future earnings to the present day. This method of CAG had met with polemics in the past when the total loss to the exchequer in the 2G scam was pegged to be ₹1,76,000 crore. 

CAG has questioned whether a state government can actually undertake an external commercial borrowing. Under Article 293(1) of the Constitution, the executive of a state can borrow within the territory of India, while the same article also states that individual states may not raise any loan without the consent of the central government. 

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However, KIIFB is an entity incorporated as a company under the Companies Act by the Kerala government. It acts as an intermediary when it comes to raising funds for infrastructure projects in the state. According to RBI guidelines, any entity that is eligible to receive foreign direct investment (FDI) can borrow overseas.