By Suvashree Choudhury and Manju Dalal
MUMBAI/SINGAPORE (Reuters) - A Reserve Bank of India (RBI) ban on Indian banks buying new issues of infrastructure bonds has handicapped Prime Minister Narendra Modi's chances of gathering billions of dollars needed for mega-projects through the bond market.
Elected in May, Modi has made heavy infrastructure investment and construction of affordable housing for all by 2022 key elements of a reform agenda aimed at getting India's lumbering economy to grow a lot faster.
Meeting the housing goal alone would need investment of at least $2 trillion, according to a KPMG report released last month.
Faced with those funding needs, the government in mid-July encouraged banks to issue bonds to fund infrastructure by exempting these bonds from reserve requirements, in order to enable them to extend cheaper loans to the cash-starved sector.
The trouble is the RBI issued guidelines a week later that barred banks from buying bonds issued by other banks in order to forestall risks arising from circular trading, whereby lenders agree to buy each other's bonds.
The RBI is hoping for greater investor participation by the likes of insurers, pension funds and mutual funds. But, analysts and bankers say the ban hampers secondary market liquidity and prevents the creation of a deeper market.
Banks are traditionally the biggest buyers of debt, and without them the market for these bonds has become so illiquid that other investors are reluctant to buy.
"Banks are the market makers, the largest investors and underwriters of corporate bonds," said Shashikant Rathi, head of investments and capital markets at Axis Bank.
"If banks are not allowed to invest in these senior infrastructure bonds then other investors like mutual funds would be sceptical buying them since they wouldn't be sure of being able to sell them if liquidity need arises," he said.
Given these constraints, few banks have made fresh issues, despite the incentives, and those that have, have received a lukewarm response.
Analysts said the RBI would have to relax its ban if it wanted bond funding to raise anywhere near the 500-600 billion rupees ($8.3 billion to $9.9 billion) in infrastructure bonds that traders say can be raised in the year to March.
Typically, Indian banks are the largest providers of loans to the infrastructure sector. Private or foreign investors have usually shied away due to bottlenecks such as complicated approval processes and red tape.
Rowing back on guidelines issued so recently would be a test of how responsive the central bank has become to market needs.
Long regarded as a staid institution, the RBI has been reinvigorated by Raghuram Rajan, the former International Monetary Fund's chief economist, who was appointed governor a year ago.
For evidence of the effect of its ban, the RBI can look at the mild response to the three infrastructure bond issues made since the guidelines were given.
Between them, ICICI Bank Ltd, Kotak Mahindra Bank Ltd and Andhra Bank Ltd managed to raise just 49 billion rupees ($811 million).
None could exercise their greenshoe options, or the extra amount that issuers sell if they see strong demand, as had been the case in previous debt sales in India.
"If banks were allowed to invest in senior bonds, we would have seen issuance three times more than what has already happened", said a debt capital markets banker at a domestic bank.
The funds raised were also more expensive than expected, as investors demanded a premium because of the illiquid market.
ICICI Bank, for example, sold 35 billion rupees of bonds this week at an annualised yield of 9.46 percent. Although not a direct comparison, traders noted that similarly rated state-run Rural Electrification Corp is trading at a 9.35 percent yield.
An investor at a domestic institution explained the lack of enthusiasm for a bond that might otherwise have seemed attractive.
"We felt there would be demand as there is hardly any AAA paper available in the 10-year segment. But after buying we saw that there was no end-investor demand, so we haven't bought any more," he said.
Bankers said the RBI could ease the restrictions from an outright ban by limiting what percentage of a bank's net capital could be invested in infrastructure bonds. Or it could allow banks to buy and trade bonds for a certain number of days in order to make a market and ensure liquidity.
The RBI, however, shows little sign of budging.
"We are ready to give the market more time to develop, understand the product," said a senior RBI official. "There will always be investors for such high-yield papers."
(Editing by Rafael Nam, Nachum Kaplan and Simon Cameron-Moore)