The Hindu Business Line : Antidote to correct the present anomalies

Conducive regulatory environment, encouraging banks to act as market makers, creating a sound secondary market for easy entry and exit of investors through easy liquidity, educating investors and providing them with the right package of tax sops alone will ensure an efficient debt market, says PRIYA MOHAN.

The financial reforms during the 1990s laid the edifice for a metamorphosis in the Indian financial sector. During this time that debt markets also started taking shape and some amount of innovation in the instruments – zero coupon bonds and inflation index bonds – happened to lure some investors.

Despite the impressive start, the debt markets till date have failed to see the levels of growth and sophistication as did the equity markets. Weak debt markets – underdeveloped corporate bond markets and secondary bond markets – have had a significant impact on the efficiencies of borrowing.

Resources locked up

Furthermore, it has fuelled the anomalies arising due to ‘priority sector lending’ and the corresponding ‘asset-liability’ mismatch within the banking sector. The ‘priority sector’ lending by the banks to many unproductive areas is a major intervention to ‘efficient allocation’. Sectors that warrant a long gestation period only to generate ‘uncertain’ returns are being funded through the ‘priority sector’ lending resulting in locking up bank’s resources for a significant duration .

Besides the risk of negative returns on investment, banks suffer an ‘asset-liability’ mismatch due to this situation. As a result, profitable and shorter gestation ventures loose out on capital opportunities.

The Development Finance Institutions (DFIs), which were started to fill the gap of lending to time consuming yet ‘imperative for development’ projects, is witnessing a change in their roles post the liberalisation era. With the approaching need for opening up the banking sector, commercial banks are also desperate to change their roles, clean up their books and optimise lending processes to become globally competitive.

Disconnect

More and more banks are shifting towards advising clients in capital markets activities and helping them raise monies. The absence of active debt markets hence fails to address the needs of those corporates with a significant ‘leverage’ potential. Here arises a disconnect – with one part of the financial economy striving to align with the market forces and other politically influenced part throwing interventions and impediments under the umbrella of ‘social-responsibility’. The losers are corporate borrowers with sound projects and who are currently dependant on ECBs and other private investments. A lack of an efficient debt market only exacerbates this problem.

Vicious cycle

On the other side, lack of sound debt markets will result in pricing anomalies for the existing debt instruments with the prices of bonds dependant on monetary policy decisions and not on fundamentals. Hence, this generates a vicious cycle.

Raghuram Rajan in his paper ‘The Paradox of Capital’ through empirical study has also pointed out that contrary to standard economic principles, countries with lower capital per worker and high growth are witnessing fund outflows to countries with higher capital per worker.

The reason pointed out is high spreads due to risk premium that keeps out risk-averse investors and weak financial markets as envisaged in the under-developed debt markets. Hence, the development of the bond market will have a more far-reaching impact in correcting some of the inefficiencies plaguing the financial sector.

Market-driven solution

While one can argue that India is a peculiar economy and one needs to adopt a tailor-made solution, nevertheless a ‘market-driven’ solution that addresses the divided concerns of the financial sector participants would not only be more effective but also non-myopic. The development of the debt markets is one such solution that would mitigate the above problems by bringing in the discipline of free market forces to ‘resource-allocation’.

For a solution, one needs to identify the core issues that stand as hurdles to the bond-market development. These are lack of liquidity, absence of effective institutional support and transaction costs, all of these leading to discouraging the corporate houses from raising monies in the debt markets.

Most economists in voicing their concerns about the under-developed debt markets compare the same with the equities. Hence, it is imperative to identify the key catalysts that drove the equity markets and rationalise these drivers to help improve the bond markets as well.

Primary impediments

Like with any markets, there are the two-sided network externalities – the borrowers and the investors and development would include enhancing the participation of both. Mere development of sophisticated debt instruments would result in attacking only one side of the problem. From the borrowers’ perspectives, transaction costs and regulatory hurdles are one of the primary impediments that lead them to seek foreign borrowing streams.

Creation of a conducive regulatory environment alone would facilitate companies to make use of domestic bond markets. Focus on reducing time to market and procedural bottlenecks would largely help. Companies that operate huge infrastructure projects and rely on private placement of debt and term lending, could be encouraged to participate in the bond markets through recommended regulatory relaxations.

Market Makers

As of now, commercial banks and other specialised institutions such as IDFC have fiduciary relationships with such borrowers and are well aware of their credit worthiness. One could tap this set up to improve the bond market activities by encouraging more banks to act as market makers by helping credit worthy clients raise monies in the debt markets. It would help banks also by reducing their reliance on ‘interest-based’ income and helping generate ‘fee-based’ income.

As for the problem of transaction costs, it may persist during the short-term due to lack of economies of scale but would eventually drop. In order to accentuate this, one needs to import the technology and process sophistication adopted in the equities market to the bond markets as well.

Specialty clusters

Another angle would be to improve the borrowing muscle of certain sectors to enter the bond markets. For instance, although the SMEs fall under the ‘priority-sector’ lending, some of them are indeed profitable.

However, the size of the loan per se may be too small to warrant entry into the debt markets. This could be mitigated by encouraging the formation of specialty clusters – one example is the Sri Lankan Rubber product manufacturers’ cluster.

Furthermore, the adoption of the Private-Public-Partnership model in sectors such as infrastructure would attract investors given the combination of reliability and effective governance.

Of course, the presence of strong monitoring institutions is a necessary accessory.

The Indian bond market is active only through its primary market activities and is dominated mostly by institutional investors, who in turn impact the growth of secondary markets by holding the instruments till maturity. The focus should be to tap the savings of the retail investors, whose interest in debt instruments is evident through their investment portfolios.

Educate investors

The most important step in this direction would be to educate investors about the advantages of debt markets and this should be undertaken by the banks’ FI sales desk. Indirectly, it also calls for a lot of integration within the banking activities.

Furthermore, to attract retail investors, institutional support that disseminates information on issue quality is imperative. The Indian fixed income credit rating is yet to reach global standards. A combination of paper-rating and corporate governance rating would ally many retail investors’ fears over the bond markets.

The next step is towards aligning instruments to suit investor preferences – both liquidity and horizon. This can be achieved through innovation and developing variations in existing asset-backed securities. Solid secondary markets will ensure easy entry and exit of retail investors without prices getting affected purely on account of lack of liquidity.

The RH Patel committee recommendations towards developing the depth of the bond markets are worth priority consideration. However, one should recognise that the development of borrowers and investors need to go hand in hand.

Right tax sops needed

Furthermore, the Finance Ministry needs to exercise caution in introducing more distortions to appease current anomalies. A package of the right tax incentives to the broad investor community in the bond markets may encourage further participation.

Such incentives should not be again restricted to investments in certain sectors as this would imply an indirect subsidy fuelling sub-optimal resource allocation. Developing an efficient debt market would be a welcome effort in India’s move towards being a truly global economy.

(The author is a Chennai-based chartered accountant.)