India needs to develop a debt market

The structure of the financial system in the country is required to reflect the development of the real economy. India has developed as a rich-poor country and our financial system is required to have the sophistication of developed markets coupled with base banking to meet the needs of small businesses, farmers, individuals, etc. Pending the development of debt markets, the banking system is being asked to fulfill the job of debt markets and the government's financial inclusion agenda, which is a tall order. In addition, we have developments in regulations, which would compound the issue further. India will need huge amounts of funds for its development. As the government grapples with the imperatives of bringing public finances under control and of improving execution efficiency, the role of the private sector in this domain is likely to keep growing. The Twelfth Five Year Plan put in place by the government envisages $1 trillion worth of infrastructure investments over the period 2012-2017. Of this, $500 billion or 50% is expected to come from the private sectora significant jump from the average private sector participation rate of 25-30% during the Eleventh Five Year Plan period. Of the $500 billion worth of private sector investment towards infrastructure, $350 billion is projected to be funded through debt. Where does the private sector raise this debt from? Infrastructure projects are long-gestation projects that require long-term funding. This would typically be the domain of the capital markets. Will the domestic private

bond market be able to deliver these funds? That seems unlikely. At a mere 5% of GDP, the market for non-government bonds in India remains underdeveloped despite more than a decade of effort. This compares with a corporate bond market size of 16% of GDP for China and 19% for Brazil. Could this change? Given the experience of the past decade, it would be optimistic to expect a dramatic turnaround in the debt market's fortunes going forward. The reasons for the stagnation in the bond market are known. Here's a quick recap of what has held back the development of a debt market.

Recent Developments in Corporate Bond Market in India

by Smriti Chand Economics Recent Developments in the Corporate Bond Market in India are given below: The most important recent development on the corporate bond market is the migration away from physical certificates into dematerialised holdings at the depository. This process began in 2000, but got major support from RBIs regulations: corporate bond market i. From October 31, 2001 onwards banks, FIs, PDs and SDs were required to make fresh investments in bonds and debenture only in dematerialised form. ii. By June, 2002, these entities will be required to dematerialise all outstanding holdings of corporate debt securities. This led to a sharp rise in the stock and settlement of dematerialised corporate debt securities at National Securities Depository Limited (NSDL). The corporate bond market is highly non-transparent; hence these trends should be treated as being indicative only. The credit spread for the AAA bond has risen steadily from I

June, 2001 onwards, except for a slight fall in recent months, the credit spread for AA and A bonds has risen sharply in recent months, suggesting a sharp increase in the credit risk of second-tier firms. The corporate with higher ratings raised capital at lower rates of below nine percent. The amount raised during the period April-January, 2003 is as Rs. 33,509 crore, 26 percent higher than Rs. 26,956 crore raised during the same period last year. In January 2001, companies raised Rs. 2,690 crore through debt papers as compared with Rs. 3, 670 crore raised in the previous month. It was also lower than the average Rs. 3,424 crore raised per month during April-December 2001. All the amounts were raised through private placement. Interest rates offered on corporate bonds declined during January 2002 the range of interest rates was 7.5 per cent to 10 per cent. There is a sharp rise in the stock of dematerialised corporate bonds, from Rs. 7,960 crore in March 2001 to Rs. 59,735 crore in December, 2001. Similarly, the volume of transactions settled in dematerialised form rose from Rs. 813 crore in May 2001 to Rs. 9,499 crore in December 2001. These values are expected to continue to grow till June 2002, by which time RBIregulated entities have to completely eliminate physical bond certificates. On the equity market, NSDL holds Rs. 3,16,040 core of securities. This is 5.3 times larger than the stock of corporate debt held by NSDL. NSDL settled Rs. 12,051 crore of equity transactions in December 2001. This was only 1.27 times larger than the settlement done on corporate debt securities. Contrary to the common notion that corporate debt in India is extremely difficult to trade, a significant volume of such transactions are taking place. It has also been observed in recent years that the vast majority of corporate debt paper has been issued on a private placement basis leading to lack of transparency and liquidity in the corporate debt market. It was therefore; felt that regulatory action was needed to be taken by both SEBI and RBI to regulate this market in order to induce greater public issuance of corporate debt.

SEBI issued guidelines on September 30, 2003 stipulating the conditions to be complied with in respect of private placement of debt. These conditions governed issuance, listing and trading of privately placed debt securities. The Reserve Bank also issued corresponding guidelines putting prudential limits on banks relating to subscription to privately placed corporate debt. Subscription beyond these limits would have to be public issues of corporate debt that is then more transparent, and whose market price would potentially be clearer at any time. Subsequently, market participants made representations and suggestions and sought clarifications on various provisions of the circular from SEBI. There was a general feeling in the market that the guidelines were too stringent. Based on the feedback received from market participants and banks, RBI also modified (on December 10, 2003) the prudential guidelines for banks non-SLR investments. Besides, SEBI was advised to take steps to address the issues of (i) a simplified listing procedure for listed companies and (ii) to spell out an appropriate listing procedure for unlisted companies. SEBI issued a circular on December 22, 2003 to all the stock exchanges incorporating the above suggestions. With the development of an elongated and smooth yield curve and aided by abundant liquidity in the system, the stage is set for growth in infrastructure financing. It is needless to highlight the importance of infrastructure financing if the stated objective of attaining the developed country status for India is to be achieved. Therefore, the developments in the debt markets should percolate down to this sector as well. On its part, RBI has been actively encouraging the government and the market participants to work more on the issue and ensure credit enhancement to the sector. In the recently held 13th State Finance Secretaries Conference, a decision was taken to set up a Working Group to study the issue of credit enhancement to the infrastructure financing in states.

The private sector infrastructure agencies could also be active in the long term financing, but for this to work, the credit enhancement has to pick up. While in 1995-96, there were large numbers of issuers, today there is a substantial pool of potential investors, who need to be tapped for this credit enhancement to materialise for the infrastructure area. At the same time, a bond insurance mechanism can potentially be developed for ensuring credit enhancement and investor | safety. There have been enough indications that infrastructure needs would go up, which would contribute to an efficient functioning of corporate debt market. The crucial issues involved in developing the corporate debt market are the ways and means of elongation of maturity of corporate debt paper, improving the liquidity in secondary market, improving institutional mechanics etc. While the G-Sec markets were now fairly well- developed, the corporate debt markets needed to go a long way so that India can have a well-integrsited financial market. An integrated financial market is necessary for efficient transmission of monetary policy, keeping in view the fact that it is now operated on indirect instruments. Fortunately, the foundations for developing an efficient corporate debt market have already been laid as the necessary infrastructure and institutions that have been created for the G-Sec market are already available. The regulators have also taken the first initiative in this regard with SEBI announcing its guidelines on trading and listing requirements for corporate debt and the RBI asking banks to invest only in listed and rated corporate paper on a private placement basis. The economy being on a high growth path would create higher demand for funds, especially in infrastructure development. Corporate looking to raising funds from the capital markets would also require them to raise the balancing debt. With term lending from financial institutions on the decline, corporate funding needs, especially of the infrastructure segment, would necessarily have to be met by the bond market.

With these motivating factors for development of corporate debt market and a large pool of well-informed urban population with 35 cities having 10 million populations, there is a huge potential in this market for new issuers and investors. However, we need innovations in credit enhancement with the active participation of brokerage houses, retail investors etc. However, while the development of corporate debt market was an opportunity, the experience of developing the G-Sec market has shown that it is a long drawn out and arduous effort which requires cooperative and collaborative efforts from not only the regulators but also from the market participants and self regulatory organisations. The players both issuers and investors in the corporate debt market would be varied. It was therefore important for the regulators to focus attention on protecting investors interest by developing processes of clearing and settlement that would ensure a risk free environment. This calls for effective regulation and innovative approaches as well. One of these innovations could be conversion of loan market in to bond market of banks. Since the cash flows being similar and loans outstanding are significant, these loans could be securitised and bonds could be issued against them. This would lead to high credit quality and reduction in overall risks. To facilitate the growth of corporate debt market, the Reserve Bank is actively considering introduction of repos in corporate bonds, to be settled through CCIL. Participation of corporate in repo market is also being considered positively. Further, the securitisation market has been growing at a rapid pace, particularly after the SEBI/RBI introduced regulations on the private placement in debt market. To encourage the growth of this market, the Reserve Bank excluded investments in Asset Backed Securities (ABS)/ Mortgage Backed Securities (MBS) from the 10 percent ceiling on the investment of banks in unlisted non-SLR securities. However, several issues relating to regulation, listing and improvement of liquidity need to be addressed. Most MBS/ABS is issued by Special Purpose

Vehicles (SPVs) in the form of trusts which are not regulated. ABS/MBS issued by trusts cannot be listed, although these are rated. Only the securities issued by the companies can be listed. On the other hand, there is legal ambiguity on the status of the listing of ABS/MBS. Exchanges reportedly sought SEBIs clarification on the issue and it is learnt that SEBI preferred an unambiguous enabling provision in the SCRA that these mortgage backed securities can be listed.

TOWARDS

DEVELOPMENT

OF

CORPORATE

DEBT

MARKET IN INDIA* 1. Perhaps, importance of debt market could rather be better gauged from a statement made by Mr.Greenspan, earlier Chairman of Federal Reserve. He thought that the Asian crisis would have been less severe if East Asia had a functional capital market in general and a bond market, in particular. He thought that existence of a deep and liquid corporate debt market could make emerging economies less vulnerable; especially to volatile capital flows. 2. For, a reasonably well developed bond market could supplement the banking system in meeting the requirements of the corporate sector for long term capital investment and asset creation. It could provide a stable source of finance; especially when the equity market is volatile and resource requirements of the corporate entities are large. In the case of India, development of a corporate bond market has become even more crucial especially, in view of the decline and disappearance of development financial institutions and the need for raising large amount of resources for infrastructure development in the country during the next couple of years.

3. During the recent years, the expansion of corporate bond market in the Asian region has been receiving much more attention than before. The progress made, however varies widely across countries. Both,Malaysia and South Korea have made reasonable progress in this respect followed by Thailand in regard to the developing Asia. Yet going by the US or European standards the progress has been tardy; ratherinsignificant considering the actual requirements of the region, as of now. Both China and India have surprisingly lagged behind in developing corporate bond markets. 4. There is a plethora of factors responsible for the slow growth of corporate bond market in the Asian region. These are: There are only a few corporate entities in the region which are capable of meeting investor requirements in terms of transparency and governance standards. This has resulted in a yawning gap between demand for and supply of corporate bonds in Asia causing outflow of capital in search of greener pastures for safety and higher returns. Public offering of bonds being expensive, time consuming and procedure oriented, corporates have been finding it easier to either borrow from banks or make a private placement of their bonds. Corporate bond market has been an institutional market. It involves over the counter bulk trading thus making trading activity r less transparent.

Non availability of bankruptcy laws to ensure investor protection in the Asian markets has also contributed towards slow development of the corporate bond market. Corporate governance and disclosure standards available in these countries do not provide enough confidence to investors to go in for investments in bonds, as unlike banks, bond investors will be widely dispersed and therefore will have less bargaining power. Building the infrastructure required for a well developed bond market is subject to significant time and resource costs. In fact, most developing Asian economies neither have the resources, nor the skills and the required technology to embark on an infrastructure development programme with a view to revamping their bond markets.

5.In India, development of corporate debt market has been one area which is most deliberated upon and discussed about. And yet it remains the least developed of all segments of the market for reasons known to the market participants. It has also been the least regulated till recently and to some extent even today. Reforms of the financial markets seem to have bypassed this segment of the market, altogether. 6. Yet, India, has been an exception in regard to many of the shortcomings observed in respect of most Asian countries. India has a legal framework in place to provide for regulatory oversight and investor protection. It has a fairly developed financial sector segment of the market which is reasonably free of controls. It also has quite a few corporate entities who could take advantage of the bond markets for its requirement of financial resources. It has the required infrastructure in place and has two world class stock exchanges

for trading, clearing and settlement systems. The country also can boast of reasonably well functioning depositories and a credible system of experienced credit rating agencies. Over and above, It has the required skilled manpower coupled with availability of the best technology. 7. Against this background, a fresh attempt is now being made by the Government to create a vibrant dynamic and deep corporate debt market in this country. A beginning towards such an attempt has already been made with the High Level Committee on Corporate Bonds and Securitization, set up by the Government of India, which has spelt out measures needed to realize the dream of developing such a market in this country. 8.Subsequent to the announcement of the Finance Minister accepting the recommendations of the Committee SEBIs internal group worked out a road map for implementation of a plan for the development of a corporate bond market in India. An internal Group of RBI has also recently come out with its views on the subject. I understand that In June last, the World Bank too organized a seminar wherein the relevant issues were discussed by the market participants, threadbare. 9. SEBIs internal committee has given some thought to an envisaged set up to make a beginning in the corporate debt market. As an integral part of its efforts to promote an efficient, orderly and fair financial market it has suggested setting up of a trade reporting platform for corporate debt to start with and an exchange for bond trading, clearing and settlement. Globalization being the watch word for success, perhaps we need to think ahead and forge ahead in this area providing even a hub for trading, clearing and settlement of Asian bonds . Let us for a while think of ourselves as the rock stars of an Asian bond market of tomorrow. Since we need not reinvent the

wheel, the fact that India is yet to develop a domestic corporate bond market should not deter us from achieving this goal.

10.Some steps towards achieving this objective could be: Setting up a corporate bond trade reporting system to ensure real time dissemination of information on bond trading; Setting up an exchange exclusively for bond trading with appropriate arrangements for clearing and settlement as soon as the trade reporting system stabilizes and generates the required information on bond trading for dissemination; Taking appropriate measures to widen and deepen the bond market. This could include enhancing the investor base, introducing a class of market makers, sorting out of taxation issues etc. Evolving a self regulatory organization on the lines of the National Association of Securities Dealers in the US to help ease the burden of SEBI in regulating the bond market could be an integral part of the plan. Establishing optional platforms to provide facilities for online public offerings in different ways to investors and setting up a scheme of repurchase agreements in corporate bonds to enhance liquidity of bonds could be added features of the project.

11. Once the domestic segment of the exchange fully stabilizes, an international segment of the exchange could be opened for

listing of Asian bonds to facilitate Asian issuers of corporate bonds to undertake their trading activities. This will be in tune with the decision to explore the idea of setting up an international financial centre in Mumbai, on the one hand and the move towards capital account convertibility on the other. Such a move would enable Asian countries which have amassed about $2.73 trillion of foreign exchange reserves have avenues for investment within the region.