Debts & Loans

Since debt investors get only a fixed income, the premium they demand rises significantly unless they are able to hedge their risks.

As India embarks on a secular high growth trajectory, the vast capital resources required to put in place our basic infrastructure like transportation, power and telecommunication or augment manufacturing capacities are well documented. The Planning Commission puts the infrastructure investment number at Rs 20,00,000 crore (11th Plan). The size, scope and scale of projects need to increase exponentially. A single ultra- mega power plant project requires Rs 20,000 crore and we need several of them.

The writing has been on the wall for some time but the importance of the financial sector reforms cannot be emphasised enough in facilitating much needed access to capital in making this Indian dream come true. While we can credit financial sector reforms implemented over the last decade-and -a-half as the foundation on which economic reforms have successfully progressed, more is needed for India to grow consistently to meet its aspirations. The financial sector has to become a much greater enabler and facilitator of providing capital.

India focused on reforming the equity market during the initial phase of the financial sector reforms by allowing access to all types of investors, including foreign investors, and by providing them the wherewithal to hedge risks through an equally efficient derivative market. Today, the equity market is a role model for change. It shows the liquidity and market efficiency that can be achieved, under Indian conditions, if a proper market design is put into place. It also shows the extent of primary capital formation that can be achieved; in 2007 over Rs 130,000 crore was raised through primary issuances.

However, equity forms only part of the capital requirement. There has to be debt backing that equity, at least at rupee-for-rupee levels, for any project to be financially rewarding to the entrepreneurs who take risks. Hence, it is imperative that the second phase of reforms focuses on the debt market. Perhaps we could learn from the equity experience and apply that knowledge to debt markets?

Transforming debt markets: The efficacy of a capital market depends on three factors: efficient price discovery mechanisms, access to all issuers and investors, and the freedom to innovate and evolve with the times. It is important to address reforms along these lines and here is what I believe needs to be implemented to transform our local debt markets.

Arguably, it is more important for debt investors to hedge themselves. Debt investors only receive a “fixed income” at the end of the day, unlike equity investors who stand to reap significant upside potential. Corporate bond investors are exposed to liquidity, benchmark interest rate and credit risks. In a rising interest rate and tight liquidity scenario, the premium demanded by investors jumps significantly unless they have an ability to hedge these risks.

Due to the surfeit of overseas issuances and cross currency swap benchmarks, it is possible to normalise local AAA levels to extract the “illiquidity” premium as demonstrated in the table. It not only shows a rising premium in a rising interest rate environment but also seems to imply that the lack of liquidity and the inability to hedge benchmark rates should translate to at least a 100bps premium locally. That is a significant cost to pay for the inability to hedge these risks.

So clearly the ability to manage underlying liquidity, interest rate and credit risks is important for efficient price discovery. It can also potentially provide access to lower credit rated issuers, which in today’s polarised market (AAA/AA+ issuers account for 80 per cent of bond issuance) have become the “untouchables”.

Hence it is important to facilitate the following:

- Repos on corporate bonds to provide liquidity
- Shorting of G-Secs to manage underlying benchmark rate risks
- Exchange-traded Interest Rate Futures to better hedge interest rate risk
- Credit Default Swaps (CDS) market to enable investors to insure against defaults

Unshackling investors: The other important factor is to promote investor democracy. Today, hardly 10 per cent of the Provident Fund (PF) corpus is available to the private sector, based on their investment guidelines. At a time when public sector investments have plateaued and private sector investments are driving growth, it is unfortunate that their access to this very liquid, long-tenor capability is restricted.

Hence, the steps being considered to allow PFs to have access to professional fund managers by relaxing and rationalising their investment guidelines are steps in the right direction and we need to move ahead quickly on this path. Insurance companies face similar issues, albeit at muted levels to that of PFs. Hence, it is important to focus on investment limits based on ”ratings” rather than “issuer” conditions. The empowerment of these investor classes will significantly deepen the local bond market.

In the case of banks, incentives must be provided through lower capital adequacy requirements and higher limits for corporate bond ‘Hold-To-Maturity’ categories. This will encourage them to extend credit through corporate bonds since their liquid nature would help banks better manage their exposures. At the same time, it is important to distinguish that banks’ treasury desks could be trading in these bonds and they should be allowed to evaluate such instruments on the basis of “market risk” rather than “credit risk”

Foreign institutional investors not only can infuse large doses of capital into the market but also provide much needed investor diversity. Their global experiences in financing infrastructure, complex projects or weaker credits can help anchor financing for domestic projects and credits.

Also, steps that include financial incentives must be taken to encourage retail investor participation directly through the bond route. The FIIs and retail flows have been primary drivers in raising equity capital for issuers and we need to provide them better access to debt markets to help mobilise capital. In order to maintain market vibrancy and channel capital efficiently, innovation has to be encouraged by providing enough latitude for market players to come up with new instruments and new investment avenues. Regulations need to be kept in step to draw the right boundaries and shape investor accessibility.

With a polarised debt market where investor preferences are skewed towards top rated issuers, it makes a lot of sense to promote active institutional credit enhancement mechanisms by banks and insurance companies that better understand credit risks. As boundaries between traditional equity and debt investors shrink, hybrid instruments including bonds with embedded equity options/warrants help harness investor interest. With infrastructure capital needs mounting, there may also be a call to look at specialised debt funds with appropriate fiscal concessions to channel public savings effectively into infrastructure financing.

Risk Management, Currency Markets:

As India Inc internationalises amid increasing volatility across markets, there is an urgent need for tools that can help corporates manage their business and financial risks. Regulators have taken the right steps over the last several years to introduce relevant tools in the market, such as rupee FX options and currency futures. Currency futures is a recent introduction that can go a long way in developing a transparent exchange-traded market with retail participation. Further enhancement in the risk management area is critical, and regulators could study further moves such as the introduction of rupee interest rate options and economic-exposure-based hedging, while enhancing the reporting and disclosure requirements through the introduction of appropriate accounting standards.

The financial sector is an engine of transmission; a catalyst that provides critical infrastructure support to energise and enable growth. As a caveat, I must also mention that the global financial sector faces the challenge of rapidly adjusting to not just economic but also political and social volatility. The Indian financial system is not immune to this universal phenomenon. While initial steps have been taken in the right direction, more must be done to fulfill India’s desire to occupy the pedestal of a global economic superpower, which it rightfully deserves.