MUMBAI Prime Minister Narendra Modi's efforts to rescue India's ailing power sector and end the country's notorious blackouts are creating an unforeseen headache for state governments: investors are suddenly shying away from their debt.
Foreign bond investors, who were falling over each other to buy state government debt just a few months ago, are now giving it a wide berth as Modi's plan calls for states to take over 75 percent of the debts of their utility companies over two years.
Those debts have swelled to 4.3 trillion rupees ($65.3 billion) after years of undercharging customers for electricity as state governments sought to win votes.
Investors fear a flood of new issuance by states under the rescue plan and at a higher cost. Indeed, RBI data shows state governments are already having to pay sharply higher bond yields to attract domestic buyers.
"We would much rather go for a AAA-rated corporate that has less supply risk compared to state development loans at the moment," said Leong Lin-Jing, fixed income investment manager with Aberdeen Asset Management in Singapore.
State governments already rely on debt markets to fund 75-80 percent of their gross fiscal deficits, allowing them to divert revenues from other sources such as taxes to fund critical programs such as welfare and infrastructure spending.
One top state government official said his state may need to borrow an additional 80 billion rupees to make interest payments on utilities' debt that it has to absorb, in addition to 200 billion rupees it had planned for the year ending in March.
"It is a disaster for states, especially those which are fiscally healthy," the official said, requesting anonymity.
The government is pushing states to buy into the plan so it can overhaul India's creaky power distribution sector. Massive utility debt has clogged up banks with bad loans and prevented power companies from new investments which would provide reliable electricity in Asia's third-largest economy.
Other federal moves could add further strains on states.
The federal government has announced a nearly 25 percent hike in salaries and pensions for its employees. Brokerage Religare estimates a corresponding hike for around 10 million state and local government employees could cost 2.4 trillion rupees.
The moves have spooked investors. Despite offering some of the highest yields in Asia, overseas funds have bought only 7 billion rupees ($104.24 million) of the 38.5 billion rupees in regional debt available to them start of this year.
In contrast, a similar tranche in November was snapped up in three days, soon after India opened up its debt markets to foreign investors.
India had hoped the entry of overseas funds would step up competition for funds and spur more secondary trading in a market that normally sees little trading.
Meanwhile, yields on state government bonds for domestic investors have risen by 30 basis points (bps) since November to 8.30 percent on average.
"I won't buy more state government bonds now, as already my previous investments in these bonds are seeing mark-to-market losses," said a treasury official at a large state-run bank, which just a month ago was a major investor.
($1 = 67.1525 Indian rupees)
(Editing by Paritosh Bansal & Kim Coghill)
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