OREANDA-NEWS. The Reserve Bank of India's (RBI) proposal to allow banks to issue 'masala bonds' - rupee-denominated bonds issued in offshore capital markets - would widen the investor pool and ultimately deepen the market for Additional Tier 1 (AT1) and Tier 2 (T2) bond issuance, says Fitch Ratings. This measure would ease a key constraint for banks in accessing new AT1 and T2 capital, given the limited size of the domestic investor pool relative to the scale of the capital needed. Fitch estimates a capital shortfall of USD90bn over the next several years as Basel III regulatory requirements build from the financial year 2017 (FY17) to FY19.

The RBI's proposal came as part of a series of measures pertaining to India's fixed-income and currency markets announced on 25 August. Fitch has long maintained that Indian banks would find it challenging to raise sufficient AT1 capital through the domestic markets. This is the case even as most of the capital needed will be required to be denominated in rupee owing to the currency structure of most banks' balance sheets. As such, enabling banks to issue masala bonds opens a window to a much larger investment pool while simultaneously addressing the problem of currency mismatches which had existed with previous international bond issues.

The masala bonds market remains in its infancy, however, with the RBI's initial regulatory framework put in place only in September 2015 - and the first issues, by corporates HDFC and NTPC, only completed in July and August, respectively, this year. As such, the extent to which banks will be able to use the masala bonds channel to raise capital remains to be seen, and will depend to a large extent on foreign-investor risk appetite and pricing.

The public banks' sharply deteriorating financial profiles over the past two years has raised their standalone credit risks and put their viability ratings under pressure. This in turn is likely to affect overseas investor risk perceptions and their expected risk premium. Furthermore, removing the foreign-currency risk for issuers will still mean that masala bonds will pass this risk on to investors. Weak rupee liquidity in overseas markets will add to the potential currency risk for investors, and raise the expected risk premium.

Therefore, the RBI's proposals have the potential to open up an international investor base to mid- and small-sized banks for the first time, while those firms with weaker credit profiles may find it difficult to use the masala bonds avenue to raise significant new capital.