Sun Capital Advisory Services : India’s elusive bond market

The expectation that financial liberalisation would lead to a proliferation of non-bank financial companies and an expansion of the bond market in India has been belied

Jayati Ghosh C.P Chandrashekhar

In recent times, much concern has been expressed about the poorly developed corporate bond market in India, which is seen as hampering the financing of long term investment. There is much evidence to suggest this is indeed true.

As Chart 1 shows, in 2014, the ratio of loan liabilities (largely to the banking system) in the total of loan, note and bond liabilities was way higher in India than in its Asian counterparts and relative to its partners in the BRICS grouping.

What is more, the increase in bond financing relative to the expansion in bank credit in the period between 2009 and 2014 (or after the global financial crisis) was much lower in India than in most other emerging markets of relevance, excluding Indonesia (Chart 2).

An era has ended

This lethargy in India’s bond market is not because of the absence of any effort on the part of the government to promote that market. In fact, the government has also held the view that a vibrant bond market is a prerequisite for the financing of long-term investment in the post-liberalisation period.

In the past a large part of such financing was supported with allocations from the budget in the case of public sector projects or with credit from the development finance institutions (DFIs) for private projects. The DFIs themselves were supported with concessional funds from the RBI and the government, especially the former, which had a separate window for the purpose. That era has, however, ended.

The government’s failure to mobilise adequate resources through taxation and its post-reform emphasis on fiscal consolidation, which limits its borrowing, has reduced its capital spending.

This requires the private sector to play a greater role in capital intensive industries and infrastructure. On the other hand, a consequence of Indian-style financial liberalisation has been the conversion through reverse merger of the DFIs into regular commercial banks.

ICICI Bank and IDBI Bank are all that is left of the erstwhile all-India development financing infrastructure. This has meant that the burden of financing private investment in capital intensive areas including infrastructure has fallen on the commercial banks, especially the public sector banks.

However, the maturity and liquidity mismatches between the funds sourced by the commercial banks and investments in large industrial and infrastructural projects has resulted over time in rising non-performing assets in the books of these banks. So they too are retreating from financing of investment in these areas.

Hence, besides foreign borrowing, a liquid bond market has become the only possible alternative to clear this financing bottleneck and support such investment.

To realise that alternative, investors looking for long term investment opportunities and offered the expected yield and the required liquidity as insurance have to be brought to market in adequate numbers.

Unfortunately, the penetration of the corporate bond market is almost marginal in the Indian financial sector. In 2014, while the ratio of bank deposits to GDP stood at 64 per cent, and that of domestic credit to the private sector at 52 per cent, the ratio of outstanding corporate bonds to GDP was only 14 per cent.

By the end of 2015 while corporate bond penetration in India was at around 17 per cent of GDP, the figure was close to 45 per cent in Malaysia and 75 per cent in South Korea.

Moreover, at the end of 2015, government securities (G-Secs, State Development Loans and Treasury Bills) accounted for 72 per cent of value of outstanding bonds, with corporate paper (bonds, commercial paper and certificates of deposit) contributing the balance 28 per cent.

Liberalisation fallout

The weakness of the bond market is partly the result of a larger failure of the financial liberalisation agenda. This was the failure to ensure the transition away from a bank dominated system, through a proliferation of non-bank financial institutions (NBFIs) that may have turned to the bond market for investment opportunities. As Chart 3 shows, when compared with South Africa, Brazil and Korea, the relative importance in terms of asset shares of NBFIs such as insurance companies, pension funds and other financial institutions was much lower in India.

This has been a bottleneck to the entry of saving households into the bond market (and more so the retail market for equity). The global evidence is quite clear that small investors are exposed to the debt market through institutions like mutual funds, insurance companies and pension funds. So the government’s effort seems to be to use the latter as means to bring a larger share of household savings into the corporate bond market.

It has done this in the past by persuading public sector insurance companies and pension funds to allocate a larger share of their investments to the market for corporate bonds. In addition, under the new pension scheme of the government, subscribers are required to choose some level of risk exposure as part of a move from defined benefit to defined contribution schemes. But, given the fiduciary obligations of investment managers in these funds, they tend to be cautious when following government advice.

Further, the relative importance of these institutions is far less than in many other countries. That does not help strengthen the corporate bond “market”.

Bank dependence

The Reserve Bank of India has in recent times attempted to respond to this through a host of measures. But the most important of those strengthens the problem of “bank dependence”. Banks are being roped in to render bonds less risky by extending the already existing partial credit enhancement (PCE) scheme. In September 2015, the RBI introduced a scheme under which banks were allowed to provide partial credit enhancement to bonds issued by corporate entities and special purpose vehicles.

This involves providing a non-funded but irrevocable line of credit linked to a bond issue, which companies can access to meet commitments in case they find themselves unable to meet interest or amortisation payments on the bonds. There were conditions set on this facility including the requirement that the rating of the bond issue must be “BBB minus“ or better before the credit enhancement and that the aggregate PCE provided by all banks to any bond issue cannot exceed 20 per cent of the bond issue size.

The essential aim of the PCE scheme is to reduce the risk associated with a bond and enhance its rating. With the banks taking over part of the risk, the bonds can be upgraded to investment grade, making them eligible for purchase by insurance and pension funds.

The new measure implemented also increases the aggregate PCE exposure of the financial system to any bond issue to 50 per cent (from 20 per cent) of the size of the issue, with a ceiling of 20 per cent on the exposure of any single bank. Measures such as this, it is hoped, will help resolve a problem, which has been created by the government’s own policies, of an unavoidable dependence for finances on a market that is still to mature. But in the process it is exposing banks, insurance companies, pension funds, and those who place their savings in these institutions to increased risk.