India in depth: Crying out for corporate bonds
By Andy Mukherjee
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.
India is crying out for corporate bonds. The country’s bank-dominated financial system is not well-suited to fund the $1 trillion infrastructure investment targeted by the government under its current five-year plan. Corporate bonds could be a helpful alternative, but the authorities are stifling the development of a genuine debt market.
Banks make money by transforming short-term deposits into longer-term loans and managing the risks inherent in the process. Indian lenders are no exception; they tend to accumulate longer-term assets at a somewhat faster pace than liabilities of the same maturity. About half of infrastructure loans are long term in nature, according to the central bank’s research. If the asset-liability gap becomes too large, the banking system becomes vulnerable to a confidence crisis.
Bank loans account for about 32 percent of the non-equity, external financing for India’s companies; the bond market provides just 7 percent of the funds, according to a recent working paper by the New Delhi-based National Institute of Public Finance and Policy. The bond market’s share of corporate finance has been virtually unchanged in the past 10 years.
After many years of debate, there is now at least a hint of progress. The Reserve Bank of India recently allowed sell-and-repurchase, or repo, transactions in short-term corporate paper. This will hopefully breathe life into a repo market that has refused to take off. The list of securities eligible for credit default swaps, a form of insurance protection for bondholders, is also being expanded. Some of the building blocks are finally falling in place. But even now, the bond market is not getting the emphasis it deserves. Part of the reason is the state’s apprehension about what a successful corporate bond market would do to its own borrowing costs.
The dominance of banks is a big advantage for the government, because the authorities require banks to park 23 percent of their customers’ deposits in government bonds. By helping itself to a large share of lenders’ deposits, New Delhi keeps its own funding costs down. If the finance ministry and its fund-raiser – the central bank – were to compete for those funds in a free market, the interest rate on public debt would be a lot higher.
As things stand, the real, or inflation-adjusted, rate is negative: Subtract 10 percent consumer-price inflation from nominal yield of about 8 percent, and the real rate on 10-year bonds is minus 2 percent. Since households are the ultimate providers of funds to the government bond market via bank deposits, provident-fund and insurance savings, the bargain is a particularly insidious one for them.
Corporate borrowers should, in theory, be beneficiaries of negative risk-free rates. But they also lose out. Banks charge hefty compensation for credit risk from businesses both good and bad because seizing the assets of failed companies is cumbersome and doesn’t lead to recovery rates of more than 30 percent of original loan values. Since there is practically no bond market for borrowers to tap, the only other alternative is to issue foreign-currency debt, a lousy option for companies with largely rupee earnings.
Until about 1990, before the government modernized the equity market and made it safer for public participation, financial repression in India was absolute. The bonds the government sold to the banks to cover its resource shortfall was virtually the only source for households to increase their wealth from one year to next. The part of household income that was neither consumed nor invested in physical assets such as property and gold was parked at banks, which, in turn, bought government bonds in a process that came to be described as “lazy banking” (See the accompanying chart, which shows a strong correlation between household financial savings and government deficits until the 1980s).
The patchy corporate sector that existed in those closed-economy days largely financed itself by retaining a big slice of its earnings. Since the early 1990s, though, the one-to-one relationship between the government’s savings-investment shortfall and the household sector’s surplus has progressively broken down. Households are no longer entirely dependent on bank deposits – and by extension, government bonds – to expand their net worth. Equities issued by companies and owned either directly or through mutual funds have gradually become a real alternative.
However, corporate debt never really had a chance to become a part of households’ portfolio. An overwhelming preponderance of private placements hampers the quality of disclosure. Regulations on investment mandates restrict insurance and provident funds from investing in corporate bonds in a meaningful way. Banks are not allowed to sell credit-enhancement guarantees to bond issuers. In the absence of market makers, trading volumes are limited. India also places quantitative limits on foreign investors’ participation. The absence of an insolvency code is another dampener.
But the most important bottleneck is fiscal. Over time, the government should have curbed its budget deficit. That would have created conditions for corporate debt to absorb surplus household savings. The economy’s growth rate would not have crashed to an estimated 5.5 percent in the current fiscal year from the 8-9 percent at which it was expanding before the 2008 crisis.
The trouble, however, is that the government is bent on expanding entitlements and cornering savings to pay for them. The result is an unhappy equilibrium. Private investments have collapsed, but financial savings have plummeted more, with households buying imported gold as a hedge against inflation. The current-account deficit is ballooning.
Even so, the policy focus is on expanding the banking system further. The central bank is under pressure to give out new banking licenses. But it’s hard to see how a capital-constrained and state-dominated banking system is going to fund $1 trillion in infrastructure spending. Maybe that goal is just a government slogan. But it shouldn’t be. The rest of developing Asia is rapidly moving forward. Every year that India lags behind is a lost opportunity.