Forced bonding

After the recent bad loan saga, it has become increasingly evident that domestic banks are ill-suited to meet the lending needs of medium- to long-gestation projects. Quite apart from their short-term deposit base which leads to an asset-liability mismatch, domestic banks have displayed poor skills in assessing the viability and likely cash flows of industrial projects. Worried that banks’ risk-aversion will hurt its ambitious infrastructure-building plans, the Centre has been suggesting that the bond markets step in to fund projects. SEBI’s proposed discussion paper to direct large companies to source a quarter of their credit needs from the bond markets has to be seen in this context.

While there’s certainly a need to develop a vibrant market alternative for funding projects, achieving this through a diktat is a bad idea. For one, India is already an island of high interest rates in the global context and this puts domestic industry at a big competitive disadvantage. Businesses try to lower their cost of capital by juggling between bank loans, external commercial borrowings and bond issues, depending on which route is the cheapest. Forcing companies to compulsorily source a fourth of their loan needs from the market will introduce rigidity into their financing plans, and hamper their ability to cut capital costs. Two, the domestic bond market is already overcrowded with issuers, thanks to frequent borrowings by both the Central and State governments. Forcing corporates to jostle with sovereign borrowers for their capital can only escalate their borrowing costs. Three, there’s little logic to arm-twisting large corporates to take the market route because well-known industrial houses and corporates with high credit ratings already do so. It is the less-creditworthy companies and MSMEs that shy away from the bond market, for the want of appetite for their bonds.

Overall, it is the lack of demand and secondary market liquidity for long-dated bonds that present the biggest impediment to the markets meeting the long-term credit needs of industry. Nudging institutions such as foreign funds, domestic pension funds, EPFO, insurance companies and mutual funds to participate more actively in long-dated bonds is one way to prop up demand. Regulators recently allowed domestic pension funds and the EPFO to venture below AA-rated bonds to bump up yields. But this is a long-drawn process that requires these institutions to develop better credit appraisal systems. The most practical solution, in the circumstance, is to allow entities managing infrastructure projects to directly issue long-dated bonds to high net worth investors or vehicles managed on their behalf. The success of tax-free bond and infrastructure bond offers tells us that this is the most expedient solution to reducing banks’ burden on industrial financing.

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