From equity to debt

June 22, 2011

(The views expressed in this column are the author’s own and do not represent those of Reuters)

The imbalance in returns on equity and debt has caused a change in the flow of funds. Last year, the funds flow was from debt to equity. That flow has reversed from equity to debt and will make a huge difference to the funding of the corporate sector.

Take FIIs — they were keen on equity until the market gave a good return. When the Sensex dipped 11 pct from the beginning of this year, FIIs turned to other emerging markets. The disinvestment in equity in the last six months was over 800 crore rupees. In 2010, they had invested 1,30,000 crore rupees.

If the FIIs deserted the Indian stock market, they were also quick enough to divert some of the money to the debt market in India. Foreign investment in debt stands at 15,000 crore rupees, close to the ceiling government has imposed on such investment. More debt would be lapped up because the interest rate that is earned is pretty attractive.

Money invested in 91 days treasury bills, for instance, earns 7.5 pct. On U.S. treasuries, it would not earn more than 1.5 pct and on Japanese government bonds even less.

The change of equation between earnings on equity and earnings on debt has disturbed the flow of rupee funds as well. To the domestic investors, equity and mutual funds are no longer on their portfolio. The funds that were flowing to these markets are now going to banks which offer higher returns on deposits. In 2011-12 so far (up to June 3), banks’ aggregate deposits increased 1,69,628 crore rupees; in the same period last year the increase was only 56,735 crore rupees.

This change in the flow of funds will make a great deal of difference to the corporate sector. First, the funds flow is more to the banking sector which lends more for short term. Corporates also need long term capital to fund investment in fixed assets. The market for corporate bonds is too small and shallow. Hence, there will be a mismatch between debt funds available for fixed capital and working capital.

Second, corporates have to have equity before they go in for debt. The market for IPOs is nearly closed. In April, total money raised by issue of shares was a mere 2,300 crore rupees. In 2010-11, capital raised by issue of shares was 1,10,237 crore rupees. For the first time there are no IPOs in the month of June. Even PSUs had to postpone their issues to the public.

Equity is important to new companies.  Since the market for IPOs has dried up, these companies will have to wait till the market picks up and funds flow changes direction. Even for other companies, investment funding will pose problems because the debt component in capital will be increased which will raise risk as also overall cost of capital.

The funds flow in the economy has been disturbed with imbalance between equity and debt and will hit investment by the corporate sector. Perhaps the increase in interest rate has gone a bit too far without restraining inflation.

No comments so far

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see