Corporate Bond Market in India Essay

Foreword In the rush to produce urgent policy documents and briefing notes that any government has to do, it is easy to let matters that may not be quite as urgent to go unattended. However, the not-so-urgent often includes matters of great importance for the long-run well-being of the nation and its citizenry. Research papers on topics of strategic economic policy fall in this category. The Economic Division in the Department of Economic Affairs, Ministry of Finance, has initiated this Working Paper series to make available to the Indian policymaker, as well as the academic and research community interested in the Indian economy, papers that are based on research done in the Ministry of Finance and address matters that may or may not be of immediate concern but address topics of importance for India’s sustained and inclusive development. It is hoped that this series will serve as a forum that gives shape to new ideas and provides space to discuss, debate and disseminate them. Executive Summary: In this paper, we examine the factors behind underdevelopment of corporate bond market in India. We assess that one of the major bottlenecks to the development of this market lies in relatively larger costs of financing which dissuade the firms to raise finance from this avenue. We argue that the lack of transparency, inefficient market making and illiquidity of the instrument not only lead to such extra costs of financing that hampers investment in the real sector but can trap the bond market in a low level equilibrium. To alleviate such problems, we prescribe policies that ensure better production of information and increased volume of transactions that will lessen both liquidity and transparency problems and ensure efficient market making. A combination of such policies include mandatory disclosure of ratings by firms and assignment of multiple agencies for rating an issue at different points of time, minimum size of placements of (infrastructure) bonds, establishing stop loss thr eshold, among others will help breaking the trap and improve quality of issues and would eventually lead to a vibrant bond market with reduced costs of financing investment. Structure of the paper: The paper is structured in three parts. The first part, section 3 and 4 analyse how corporations finance themselves and how does the corporate bond market contribute in this process. Section 3 delves into how large Indian firms evolved in their financing pattern over the past decade. We further analyse what are some of the key drivers of such financing pattern when it comes to corporate bond markets in section 4. In section 5, we offer an analytical construct and mode that shows how liquidity, transparency and informational problems contribute not only to higher costs of financing but may create low level equilibrium trap in the bond market where few issuers, investors and market makers participate. In section 6, we summarise the policy implications of our findings and analyse what it would take for the corporate bond market to move from the current state (of low level equilibrium) to a higher level equilibrium. We examine where the policy maker might have a role to play and where th e market will respond to address its concerns spontaneously. 2. A review of how large firms in India finance themselves Our analysis about the debt market in India begins with a review about how firms in India finance themselves. Our information is necessarily restricted to the largest firms of India, those that are observed in the CMIE database. We focus on non-financial firms, so as to avoid the measurement problems of accounting data for financial firms. The `sources and uses of funds’ statement, which is the first difference of the balance sheet, yields important insights into the financing structure. Table 1: Structure of sources and uses of funds Ended 2000-01 35.2 5.7 29.5 64.6 17.2 14.4 3.5 0.5 25.5 Ended 2010-11 30.8 21.1 9.7 67.5 13.8 17.8 3.9 3.2 24.2 Component Internal Retained Earnings Depreciation External New equity Banks Bonds Foreign Current liabilities Table 1 shows the structure of the sources of funds, comparing the latest available year (2010-11) against one decade ago (2000-01). The first feature of interest is internal financing. We see a substantial reliance on internal financing: from 35.2% a decade ago to 30.8% today. To the extent that internal financing is important, it acts as a barrier against new firms who do not have pre-existing cash-flow. The hallmark of a sophisticated financial system is a substantial extent of external financing. From a normative point of view, to the extent that external financing is greater, this is likely to induce superior resource allocation and competitiveness. Turning to external financing, one important component – equity financing which was at 17.2% in 2000-01 and 13.8% in 2010-11 – is in relatively sound shape. The Indian equity market was the focus of policy makers from 1992 onwards, and substantial progress has been made. One key element – stock lending – i s as yet absent. Barring this, all sophisticated features of the worlds top equity markets are now found in India. The two Indian exchanges, NSE and BSE, rank 3rd and 5th in the global ranking by number of transactions, that is produced by the World Federation of Exchanges (WFE). The problems in India today lie in debt. Banks accounted for 14.4% of the financing of large firms in 2000-01, which went up to 17.8% in 2010-11. The bond market stagnated, with 3.5% in 2000-01 and 3.9% a decade later. Despite considerable interest in bond market development, the corporate bond market accounted for only 3.9% of the sources of funds of large Indian companies. Finally, foreign borrowing rose sharply, from roughly nothing in 2000-01 to 3.2% in 2010-11. To some extent, borrowing abroad has served as a way for Indian firms to overcome the difficulties of obtaining debt financing domestically. From a normative perspective, the picture that we see in the sources of funds is one of an excessive reliance on internal financing, a surprisingly large role for banks, and a miniscule and stagnant bond market. The next issue that we turn to is the role of secured versus unsecured borrowing. The hallmark of a sophisticated debt market is the presence of unsecured borrowing. Secured borrowing is the mainstay of a simple-minded financial system: The lender does not have to analyse the prospects of the borrower for he lends only against collateral. In contrast, unsecured borrowing requires that the lender has to understand the prospective cashflow of the borrower, which determines the extent to which the promises about future repayment may be upheld. We analyse secured versus unsecured borrowing by size quintiles, once again amongst all the non-financial firms seen in the CMIE database. In the smallest quintile, in 2001, secured borrowings were at 76.7%. A decade later, there was a small decline, to 65.37%. This shows the stubborn domination of secured borrowing, when it comes to the smallest firms. Similar patterns are found in other size quintiles also. In the fourth quintile – from the 60th percentile to the 80th percentile – secured borrowing was 84.7% in 2001 and had dropped slightly to 80% in 2011. This domination of secured borrowing suggests a debt market that has a highly limited ability (or incentive) to actually understand borrowers. Even in the top quintile of firms – roughly the 680 biggest companies of India – we do not see a meaningful extent of unsecured borrowing. In 2001, secured borrowing was 65.8%, and this dropped to 60.7% in 2011. In other words, even for the biggest firms of India, only 39% of borrowing was unsecured. The debt market was not able to analyse the prospects and give debt, based on assessment about the future, to a substantial extent to even the biggest firms in the country. This evidence shows a highly malformed debt market. The bond market is practically nonexistent in corporate financing. Forward-looking assessment is weak; even the biggest firms tend to rely on secured borrowing. 3. Key issues with Indian corporate bond market functioning The presence of corporate bond market in India is barely perceptible as compared to other economies. Despite of multiple endeavours by the government in the recent past, to revive the market, neither investors nor issuers showed any tangible interest. As a result, at least 80% of corporate bonds comprise of privately placed debt by public financial institutions. The following graph confirms inadequate growth of the bond market in India relative to the countries like US, Japan and China. Illustration – Share of Corporate Bonds in Total Debt (Source: BIS) Bond markets as well as equity market owe their difference to inherent characteristics of the instrument that underlies respective markets. The following summarise how the markets are different – Intermediaries – Market intermediaries in both bond and equity markets ensure liquidity. However the intermediaries in the bond market at present need to hold a larger amount of capital than their counterparts in the equity markets because of the larger volume of trade in each transaction. Subsequently the need to hold large inventory position is more for bond market intermediaries as compared to equity market intermediaries who have the option to do electronic limit order matching. Hence, intermediaries in the bond market are exposed to greater risks due to liquidity partly due to the absence of a secondary market where retail investors can participate along with large players. Investors – Bonds’ payoff are attractive to those who prefer predictable returns for known time horizons. As a result, bond market attracts institutional investors cautious of protecting their principal e.g. pension funds, insurers, banks, etc. This also results in relatively risk averse retail investors willing to invest in the bond market. However, casual empirical observations suggest that the share of retail investors in corporate bond market is very small. Lack of liquidity and transparency are the key reasons driving lack of investor participation in corporate bond market including retail investors. Another reason why the market for corporate bonds did not take off earlier was large scale default that undermined the system and safeguards in place. While this paper addresses how to alleviate problems of liquidity and transparency, other measures must also be adopted to reduce probability of default and increase the amount as well as speed of recovery in the event of bankruptcy. For example, it is well known that firms have a tendency to adopt excessive risky projects financed by debt due to limited liabilities. While banks can prevent such activities by placing covenants, public debt holders are powerless to do it because each owns an insignificant amount of the total debt. Many a times, the seniority of debt is debatable. On the other hand, the magnitude of the recoveries also depends on bankruptcy law which in India is very weak. Hence, strong legal systems that prevent excessively risky activities and also ensure faster resolution of bankruptcy are also preconditions for the emergence of a strong bond market. Though there might be a combination of factors that impede the growth of a vibrant corporate bond market in India, we will argue below that the lack of transparency, less liquidity and inefficient intermediation in the process of market making contribute to the current state of the market. The bullet points below succinctly summarize the impact of these three factors on the development of bond market in India. Efficiency in bond market is driven by transparency that allows bonds to be priced for all available information. Transparency in the bond market refers to the dissemination of information conveyed to all market participants 1regarding pre and post trade issues ranging from order interests to price and volume after trade is executed. Liquidity in bond market is driven by volume of bonds offered by issuers in the primary market on an on-going basis as well as the circulation of bonds in the secondary market with active investor participation. A greater the participation of investors reduces search costs of both buyers and sellers and ease liquidity problems leading to a lower discount of the bond. Liquidity problems here refer to the ease of selling the bond in a secondary market. ï‚ · Intermediaries quote both buy and sell side prices and hold inventory to enable market making. Any inefficiency in this process will be automatically reflected in the pricing of bonds and thus will adversely affect costs of borrowing of the issuers. 3.1 Transparency The Indian corporate bond market lacks both pre-trade as well as post-trade transparency. Factors limiting transparency of both primary and secondary corporate bond market are: (a) Systemic flaws in the credit rating process by the Credit Rating Agencies (CRAs) enhance risk and also reduce transparency due to a constellation of a number of factors articulated below: ï‚ §Ã¯â‚¬  Right to rate the issuers of bond is not confined to entities registered as CRAs (Credit rating agencies) and currently ratings are being done by entities not registered as CRAs. These unregistered agencies rate in a manner that is not calibrated to CRA rating standards and offer rating to not just instruments but also issuing organisations. This infuses additional noise in the production of information which may force retail investors to shy away from the bond market. For example, the SMERA which rate instruments as well as organisations for small and medium industries in a manner that very often do not mee t criteria of proper rating standards.