The RBI this month proposed to scrap a 14-year-old system under which state debt is valued at a fixed spread of a quarter-percentage point over government bonds, though it has said the recommendation is not final.
Two auctions of state debt held since the rule was proposed, including one on Tuesday, fell short of targets as investors, mainly state banks, worry that they will be forced to book losses if their holdings are subject to market pricing.
Demand has already come down for SDLs (state development loans). If it becomes a rule, then investors are staring at losses on their existing portfolio, said Anindya Dasgupta, a managing director in Mumbai at UK-based lender Barclays.
A senior official at a large state bank said some lenders may see mark-to-market losses of about 60 basis points on their state bond portfolios if the rule is implemented as proposed.
There was a bonus for investing in SDLs which wont be there anymore, he said, declining to be identified because of the sensitivity of the matter.
To improve demand, the RBI is considering auctions of state bonds in which all winning bidders pay the same price, sources familiar with the issue said.
While the old system for valuing state debt gives certainty to issuers and investors, it raised worries among policymakers that it did not reflect the risk of state credit, even though the bonds carry a sovereign guarantee.
That also deterred investor interest beyond banks, which are required to hold 23% of their assets in Indian government debt, including state bonds an arrangement that has long been criticised for enabling heavy government borrowing while stunting broader market development.
Indian policymakers have struggled to develop broader and deeper credit markets that would help companies fund costly long-term projects such as roads and power plants, and hedge their interest rate risk.
Since taking office in September, RBI governor Raghuram Rajan has relaunched bond futures with a more market-friendly design and nudged banks to shed dependency on the central bank for liquidity by capping access to overnight funds.
However, the move to reform state bond valuations began under his predecessor, Duvvuri Subbarao. The recommendations of the Committee on Financial Benchmarks are under examination, the RBI said in an emailed response.
Under the proposed rules, state bonds would be auctioned at the average spread above federal debt in the previous two auctions, aligning prices more closely to market levels.
States worry that under the new system, they would have to pay substantially more to raise debt. We will discuss this with the Reserve Bank, said a senior finance official in Andhra Pradesh, also declining to be identified. This is a matter of concern.
In Tuesdays auction, Gujarat, with an average fiscal deficit of 2.4% of output over the past three years, paid a yield of 9.75%, while West Bengal, with a deficit of 3.6%, paid 9.85%.