1. 1
Challenges for FII investments in Debt
Interest rate differentials continue to remain favourable for Indian Debt. However the arbitrage
opportunity is lower due to an increased MIFOR level.
Source: RBI/Bloomberg
There have been some positive developments in the last few months in the Regulatory environment for
investment by FIIs. These are:
 FIIs are now permitted to invest in primary market
 Fixed calendar of issuances has ensured a smoother process and reduced the cost of the limits.
Limits are auctioned every month now as per a fixed schedule;
 On GAAR, some clarity is emerging
 Adequacy of limits
1) The maximum investment limit for foreign institutional investors (FIIs) in GOI securities has been
increased from $15 billion to $20 billion. Within this overall limit, the current limit of $ 5 billion for
FII investment in Government securities with 5 year residual maturity is enhanced to $10 billion.
Further, the residual maturity for the said $ 10 billion limit is reduced from 5 years to 3 years;
2) Conditions applicable for the FII investment in infrastructure debt and non-resident investment in
infrastructure funds have been further rationalized in terms of the lock-in period and residual
maturity. The lock-in period for some long-term infrastructure bonds will be one year instead of
three years.
3) Qualified Foreign Investors can now invest in those mutual fund schemes that hold at least 25
percent of their assets in infrastructure sector under the current $3 billion sub-limit for investment
in mutual funds related to infrastructure.

2. 2
FII Debt Limit Utilization Status (as on July 04, 2012):
Category Type of Instrument
Total Limits Unutilized
Limit
Government
Government Debt –Old 10.00 0.20
Government Debt –Long Term 10.00 1.90
Corporate
Corporate Debt – Old
20.00 0.80
Debt oriented Mutual Fund
Corporate Infra
QFI investment in debt mutual fund
schemes which invest in infra 3.00 3.00
Corporate debt long term infra - 1 year lock
in with 15 month residual maturity
12.00 2.50
Investment in IDF 10.00 10.00
Total 65.00 18.40
All figures in USD bn (@USDINR 55.00)
The systemic liquidity in the Indian Money Markets has been in a sizeable deficit for a prolonged period
now. Therefore, the overall restriction on the FII investment in Indian Debt should be removed.
Moreover, even in the existing scenario, some issues remain unresolved. These are as entailed below:
1. Retrospective change in Foreign Institutional Investors (FII) Reinvestment rules - The FII
Reinvestment rules were changed retrospectively on 3rd
January 2012 ( via SEBI Circular:
CIR/IMD/FIIC/1/2012) affecting corporate bond limits issued in auction held on 30th
Nov 2011
(announced via SEBI Circular: CIR/IMD/FIIC/ 20 /2011) where FIIs had paid high fees to acquire
these limits. Such retrospective action creates a sense of uncertainty for investors and makes
them skeptical of future participation.
Recommendation:
Any change in rules should apply to future auctions only and in case any rules are changed
retrospectively, investors should be allowed to surrender the limits and get refunded on the
fees.
2. Hedging of Coupon - Current regulations allow forex hedging to the extent of market value of
entire investment as per RBI Master Circular No. 12/2011-12 published on July 1, 2011. This
regulation creates challenges for investors as they can’t hedge the coupon of the bond ( typically
around 10% per annum, resulting in one-tenth of the portfolio being potentially un-hedged).
The forward contracts, once cancelled cannot be rebooked except to the extent of 10 per cent
of the market value of the portfolio as at the beginning of the financial year.
Recommendation:
FIIs should be allowed to hedge the coupon for coupon bearing bonds and to par value for zero
coupon bonds atleast progressively as we move closer to maturity.
3. Withholding Tax- Section 115A and 195 of the Income Tax Act provides that any interest income
received by any non-resident from the Government or an Indian concern shall be taxable at the
rate of 20% on the gross amount of such interest income. Debt-focused investors mostly earn a

3. 3
spread income i.e. borrowing at certain rate in the offshore markets and investing in India at
higher rate (like Banks) or earn a return against a risk free curve (like asset managers). As WHT is
applied at gross level and not net level, the effective return for investors is severely diminished.
In the Union Budget of 2012, it has been proposed to reduce withholding tax to 5% ECB loans in
infrastructure sector. RBI has also highlighted the benefits of elimination of withholding tax.
RBI’s Draft Report of the Working Group to enhance secondary market liquidity in G-Sec and
Interest Rate Derivatives Markets mentions “…elimination of withholding tax will lead to long-
term benefits for the financial market by improving market efficiency”
Recommendation:
Withholding tax should be reduced to 5% for all FIIs’ investment to further incentivize investors.
4. Taxation - GAAR plus retrospective taxation has created lot of confusion among FIIs. We would
recommend giving utmost clarity on taxation to FIIs so that they have no concerns while
investing in India.
Recommendations:
. Feedback from investors should be incorporated to ensure genuine investors are not
hassled.
a. Market participants need to be reassured on interpretation of tax benefit clauses in bilateral
treaties.
5. Lock-in period - Infrastructure bonds continue to have a lock in of twelve to fifteen months.
While the objective of this regulation is to develop a long term market for infrastructure bonds,
it restricts the flexibility available to the FII investor in exiting the investment. Also, the limits for
these infrastructure bonds have too many sub-categories.
Recommendation: The lock in period may be removed and classification of these limits may be
simplified.