Indian Debt Markets - Need for Development.

Name: Aniket Menon and Bhavik Dave

Name of the Institute: Prin. L.N. Welingkar Institute of Management Development & Research

Indian Debt Markets - Need for Development.

In retrospect every Indian knows we cannot systematically ignore the role of slavery, the

absolutely central role of war and our fight for independence in creating and shaping the basic

institutions of what we now call “The Indian economy”. What’s more, origins matter.

It’s imperative that we look back at an important aspect in our history, slavery, whose role was

instrumental in shaping our outlook towards the market and in particular the Debt Market.

Slavery is seen as a consequence of war and if you surrender in war, what you surrender is your

life; your conqueror has the right to kill you, and often he will. And if he chooses not to, you

literally owe your life to him; a debt conceived as absolute, infinite, and irredeemable. And all

your responsibilities or obligations towards your loved ones are negated and now you are solely

indebted to him alone. This logic has an interesting consequence. Debt was hence looked upon as

being slave and equity as more participative or voluntary in India. Secondly Indians have always

looked at debt as Dakshina (fees paid to our gurus). Daskhina is a karmic debt-instrument, which

means you are obliged to pay. Charity or Daan on the other hand is an equity instrument where

you do it voluntarily; but doing so helps you earn good karma (shareholders support and brand

building). However, these logics are more relevant from the borrower’s perspective. Indian

investors on the other hand have been traditionally risk averse. It has perhaps something to do

with the monsoons of this land. Fear of droughts and floods is so ingrained in us that we prefer

being moneylenders to farmers. Interests are more secure than harvests. Read through reports

and you will know where the small Indian investor’s money is? Debt markets in India have

definitely suffered from chronic neglect on the part of policymakers, despite the fact that there is

clear evidence of fairly strong debt preference among households in their investment portfolios.

Capital markets in India are more synonymous with the equity markets – both on account of the

investors’ preferences and the capital gains it offers. But to add to its world class equity and

banking sector, the country needs to build its bond market. While they have grown in size, they

continue to remain illiquid. The corporate market, in addition, restricts participants and is largely

arbitrage-driven.

In a developing economy such as India, the role of the public sector and its financial

requirements need no emphasis. Government securities markets have traditionally dominated the

Indian Bond market. The reason being the high government deficit and the need to service it at

an optimal cost, the predominance of bank lending in corporate financing and regulated interest

rate environment that protected the banks’ balance sheets on account of their exposure to the

government securities. While these factors ensured the existence of a big Government securities

market, the market was passive with the captive investors buying and holding on to the

government securities till they mature. The trading activity was conspicuous by its absence.

The scenario’s completely changed since the nineties. The notable changes being gradual

deregulation of interest rates and the Government’s decision to borrow through auction

mechanism and at market related rates. This move towards a market-based economy meant now

resources are allocated based on the risk return profiles of alternative investments instead of

being guided by direct or indirect intervention of the Government. Also, the fact that the

monetary as well as government debt management functions are centralized in the RBI, it calls

for greater coordination between monetary and debt management policies. While the objective of

the debt management policy is to reduce the cost of debt servicing in the long term, the efficacy

of the monetary policy depends upon how efficiently the transmission mechanism works, the

basis of which is an efficiently determined interest rates structure. Also because the sovereign

paper will always acts as an benchmark for pricing corporate bonds, unless the prices of the

former reflects its intrinsic worth, markets will not be able to price the latter. All these once

again emphasize the importance of efficient price discovery mechanism.

Bond markets also had major disadvantages as opposed to bank financing. In the

absence of hedging avenues, it turned out be more risky and less flexible than bank financing.

Risk management was another issue, since the derivatives markets were not developed to enable

both issuers and investors to efficiently transfer the risks arising out of interest rate movements.

There were no exchange traded interest rate futures or options. The Mark to market regulations

also deterred banks from investing in corporate bonds and prefer traditional lending route to

finance corporates. Most issues were not Corporate Bonds but Private Placements.TDS was also

viewed as a major impediment to the development of the Government securities market. Stamp

duties also acted as a deterrent to the development of the bond markets. The stamp duty

applicable for a security differed on the basis of the class of investor and this discouraged

corporates from issuing bonds to certain class of investors like retail investors and to long-term

investors like insurance companies, provident and pension funds. Fragmentation did not further

help the development of a liquid bond market. Information and low investor base were among

the other problems faced.

Today, having addressed most of the problems mentioned above( investor

base is being broadened, issuer base is now widened, derivative markets are being developed,

price distortion issues are being addressed , listing norms are being eased, reforming stamp duty)

the idea is to look ahead at the bigger picture of bond market. The bond market should witness

exponential growth with the growing infrastructure development, budding mutual fund industry,

new pension system, developing market for securitized products, rising concerns about the asset

liability management on the part of banks along with the development of derivatives market.

India has aggressive targets for GDP growth rate at 8-10 % p.a. Investment

in infrastructure by both the government and the private sector has been relatively low in the

past. Given the quantum of funds required and long gestation periods, achieving financial closure

for large infrastructure projects has often been difficult. Banks continue to be exposed to

problems of asset / liability mismatches when they lend long tenor as such long term assets are

inevitably funded through significantly shorter tenor liabilities.

The Indian debt market and the government securities market in particular, is definitely at a

turning point in India with significant changes taking place in the domestic economic

environment .And hence this is an opportune time to reflect on future debt market development.

The economy is estimated to be growing at about 8 % this year with modest inflation and if

similar conditions prevail, we can expect growth and inflation next year to also be on a similar

path and if it’s to be maintained and accelerated in the long run, financial intermediation will

have to further improve the debt market. Needless to say the sustenance of such growth will

heavily rely on investments in both infrastructure and industry. Bond financing also has to

supplement traditional bank financing to take care of the growing credit needs of the economy.

In a very stylized sense, the requirement of investment funds for productive investment can be

divided into three broad categories – equity, long-term debt, and medium to short-term debt.

If the financial sector is unable to provide funds as required by the demand,

there would simultaneously exist excess demand and excess supply in different segments of the

financial market. In such a situation, one of two outcomes is possible. The investing entities

could meet their funds need in whatever form available; and thereby expose themselves to

needless risk. As a consequence, the over-all risk profile of the economy would tend to go up.

Alternatively, if they adhered to norms of prudence, the segment of the financial sector facing

the highest level of excess demand would prove to be the binding constraint to investment

activity and effectively determine the actual level of investment in the economy. Think about it!

It’s possible that ex-post investment may fall short of ex-ante savings, not because of a lack of

investment demand, but because of a mismatch between the structures of the demand for and

supply of investment funds. In addition, the excess supply of funds in one segment of the

financial sector carries the danger that such funds may be used for speculative purposes in

foreign exchange, real estate or commodities, which create their own problems in economic

management. The net result can be an economy which is performing well below its potential and

with high levels of systemic risk.

Clearly, progress has to be made in creating the infrastructure and implementing

the policy regime that is needed to facilitate the evolution of the Indian debt capital market into a

global participant. Further progress in this regards, would only facilitate greater access to credit

by enabling risks to be shared by banks and other investors.

References:

1. Developing the Indian debt capital Markets: Small investor Perspectives.Bose, S. and Coondoo, D. and Bhaumik, S.K., “The Emerging IndianBond Market: A First Glimpse”,http://papers.ssrn.com/paper.taf?abstract_id=239289  2. Bose, S. and Mukherjee, P., “Constant maturity yield curve estimation forIndia”, Presented at the 4th Annual Conference on Money and Finance -IGIDR, Mumbai 3. Echeverri-Gent, J. and Shah, A. and Thomas, S., “Globalization and theReform of India’s equity markets”, Presented at the 97th Annual meeting ofthe American Political Science Association, San Francisco, September2001. 4. Huang, J. and Huang, M., "How Much of the Corporate-Treasury YieldSpread is Due to Credit Risk?", Working paper, Oct, 2002http://www.stanford.edu/~mhuang 5. Majumdar, S., “Indian Money and Fixed Income Securities Market – AStudy of evolution”, www.debtonnetindia.com