India's move to ease restrictions for foreign investors in domestic debt markets is unlikely to significantly boost capital inflows unless the government also cuts withholding taxes, a more difficult decision for a country with fiscal challenges.
Government bonds gained mildly after India removed some of the restrictions on debt purchases by foreign institutional investors (FIIs) on Saturday.
The government had already taken other measures to attract capital flows such as simplifying the "Know Your Customer" registration rules for overseas investors after Finance Minister P. Chidambaram met FIIs during a trip abroad in January.
But analysts said the key stumbling block in attracting foreign investment remained a withholding tax of up to 20 percent on the interest paid on India debt.
"We think this is clearly a step forward in easing the rules for FIIs in debt markets, and combined with recent easing of Know Your Client norms, it may at the margin be positive for bonds, particularly for corporates," Barclays Capital said in a note on Monday.
"However, the regulation falls short of market expectations of lower withholding tax on government bonds."
Under the new rules, India will create two broad categories of debt: Foreign investors can invest up to $25 billion in government bonds, including both long- and short-term debt such as treasury bills, and up to $51 billion in corporate bonds.
That removes separate limits on different types of debt, doing away with a complicated system of categories for debt and restrictions on which types of investors can bid for the debt.
The move should especially benefit corporate bonds, where total foreign investment, including in infrastructure, was estimated at about $21-$22
Foreign holdings of government bonds is higher at about $22 billion for all maturities, according to brokerage Derivium Capital.
The government's easing of investment controls is intended to bridge a record current account deficit of 5.4 percent of gross domestic product at end-September, which was a key reason behind Standard & Poor's and Fitch Ratings decision to cut their outlooks on the country to "negative" lat year.
"It was a messy situation. This (reform) will result in more inflows in government and corporate bonds," said Ajay Manglunia, head of fixed income at Edelweiss Capital.
Although India has attracted strong foreign demand in recent months for bond quotas that allow them to right to buy debt, analysts say the withholding tax has been a deterrent, with some of those quotas going unused.
Cutting the withholding tax is a far more difficult choice for the government, which is looking to meet its fiscal deficit target of 4.8 percent of GDP in 2013-14 by raising tax revenue.
Cutting taxes on foreign investment earnings could thus attract capital flows, but would put pressure government finances.
Lowering taxes could also lift debt markets at a time when government bonds have sold off after the 2013-14 budget that broadly disappointed investors, and the Reserve Bank of India issued a cautious statement on future rate cuts.
The benchmark 10-year bond yield was down 1 basis point at 7.95 percent as of 0635 GMT. The yield is not far off the 8 per cent hit at the end of 2012, after falling to as low as 7.78 percent earlier this year.