The long and short of it

“Some see financial markets as competition to banks. They are that, but they are also complementary. Too many risks in the Indian economy gravitate towards commercial banks even when they should be absorbed by arm’s length financial markets. But for our financial markets to play their necessary roles of providing risk absorbing long term finance, and of generating information about investment opportunities, they have to have depth”. That was a recent statement from RBI Governor Raghuram Rajan.

The Governor was obviously referring to the increasing stress on account of non-performing loans in Indian banks’ balance-sheets — primarily on account of long-term loans made to the infrastructure sector, namely, in power, roads, aviation, telecom, metals and other sectors; and how banks could have well avoided all that stress if India’s domestic financial markets were developed enough to provide long-term finance. This would allow banks to focus more on providing short-term working-capital finance to industry and projects.

(Non-performing and restructured loans of Indian public sector banks are now nearly 10-11 per cent of total assets, doubling in the last four years).

Why no depth?

The question therefore naturally arises: Why do Indian markets not have the required depth to provide long-term project finance?

The answer is really simple. It is because such long-term (private sector) financial contracts as 10 or 20 year bonds are completely absent here in India.

(The public sector, namely, the government, has such long-term financial contracts as a borrower on the terms it prefers; that is on account of coercion and financial repression rather than a mutually-beneficial financial relationship between the borrower and the lender. As we shall presently see, this is one of the critical reasons why the private sector market is non-existent).

And, why are such long-term private sector financial contracts absent?

They are absent because the risks in such long-term contracting — inflation risk and market and credit risks which flow from the inflation risk — are so high that borrowers and lenders are not able to come together on mutually-acceptable terms at all. Therefore, bond markets here are stunted.

Indeed, if we make a long-term study of the Indian economy and financial markets, it would exemplify the widespread cross-country experience — that high-inflation economies will inevitably suffer from stunted bond and banking markets. The Indian experience is actually even more poignant. Stunting in the bond markets inevitably leads to stunting in the banking markets — but, it is more so here in our case given the public ownership status of 70 per cent of the banking system.

All projects and proposals which are not capable of getting financed in the “private market” inevitably get dumped on the public sector banking system.

What risk in inflation?

It is even more aberrant when you consider this. Indian banks’ deposit yield curve is always inverted (higher short-term than long-term rates of interest). That is a clear vote of no-confidence in government/the RBI’s ability to preserve the value of money into the future.

With an inverted yield curve, Indian banks’ overall deposit maturity is relatively very short (one to three years) vis-à-vis the long-tenor project loans they are forced to carry.

So, how does high inflation hinder the development of long-term financial contracts and markets?

Long-term financial contracting such as 20-year or 30-year bonds requires that both lenders and borrowers should be reasonably confident about the purchasing power of the money — over the term of the contract — they are dealing with.

When there is high inflation uncertainty, such financial contracting becomes near-impossible. If the inflation rate turns out to be higher than anticipated, a borrower gets to repay in less valuable terms at the expense of the lender who gets less back in purchasing power than expected.

If the inflation rate turns out to be lower than anticipated, the lender gains at the expense of the borrower (assuming the borrower is able to make the greater real payment). (You can note here that governments as borrowers will always be biased towards “high, higher and highest” inflation — it “lightens” their debt load).

Inflation, by altering the real values of nominal cash flows, therefore has a significant influence on all borrowing and lending, including the short-term. It will be more so, and will in fact be critical when we talk long-term.

When the future inflation rate is highly uncertain, so that the risk of such gains and losses on new contracts is great, it will be difficult to find borrowers and lenders willing to take on such long-term risk.

Again, cross-country experience shows that inflation becomes more variable as the average inflation rate rises making long-term contracting even difficult to contemplate. The real returns from holding bonds and loans of long maturities — for example, 30-year corporate bonds or 30-year fixed-rate mortgages—are especially sensitive to inflation variability. When an economy moves to higher and more variable inflation, therefore, such long-term contracts disappear. Long-term investments are discouraged by the greater risk in financing them.

Therefore, it is no surprise that Indian financial markets lack the depth to provide long-term project finance.

We are a high-inflation economy and that has effectively ruled out the development of private sector long-term financial markets.

And, one of the key causes of that high-inflation environment is the government’s monopoly of a long-term financial contracting market — a monopoly created by financial repression and compelling the central bank to monetise its long-term deficits and borrowing.

Problems not only for banks

Overall, there has been a forced transfer of risks on to public sector bank balance-sheets in India. Tragically, the problems do not end there.

Without a robust domestic long-term financial contracting market, our borrowers have even ventured into long-term foreign currency borrowing in overseas markets. That has opened up a separate battle front as the rupee’s travails over the past two years show.

(The author is a Chennai-based financial consultant.)

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