Debt markets in India

It is of no doubt that a vibrant, well-functioning public debt market helps diversification of:
(1) funding sources for borrowers, and
(2) investible alternatives for investors;
thereby freeing up available choices, which go a long way in the overall financial market development. Debt could be issued by borrowers like banks & financial institutions (FIs), state/national government, corporates, and even local governments. Indian debt markets, especially issuances from corporates and local governments, are still in very early stages of development, and the bond market is largely populated by government / quasi-state issuers / public sector enterprises (PSEs). Debt financing is mostly of 2 kinds: (a) bank loans (b) bond issuances.

Bank loans typically have bespoke contracts negotiated between the borrower and the lending bank. Towards monitoring the financial health of the borrower, these contracts contain covenants like a debt service coverage ratio (essentially the cash/liquidity available to a borrower to pay the loan interest), again bilaterally negotiated and not easily observable. Typically, assignability/novation of loans from one lender to another requires the consent of the borrower, which restricts transferability of the loan. All these factors make bank loans a relatively illiquid financial instrument. Loans thus tend to remain bilateral facilities and lenders largely account for them on their hold-to-maturity books, restricting active trading of these instruments. Further, lenders depend on borrowers providing their own financial information, which makes transparency a big question. The concept is the same across European and US markets as well, where the market for trading loans is more esoteric and is restricted to a limited set of participants. Many of these loans also get issued without publicly available ratings by credit rating agencies, further restricting their liquidity and tradability. In India, apart from these problems of reduced liquidity and borrower transparency, the market for bank borrowings is unfortunately compounded by the relatively weak bankruptcy code and stressed legal system. Lenders find it increasingly difficult to enforce upon the assets of a defaulted borrower, court cases go on forever, and the proportion of non-performing loans (NPLs) keeps building up in the books & records of banks/lenders; which is a problem rampant in Indian banks today (across both state owned lenders like SBI and privately owned entities like ICICI).

Bonds however, are transferable debt instruments, typically issued to a larger set of investors. The transferability arises from their listing on exchanges, standardised documentation and reporting. However, most of the bond issuances in India today are either restricted to private placements or are issued by a restricted set of borrowers like banks/FIs and governments/PSEs. Corporate and municipal bond issues, as I mentioned earlier, face entry barriers on account of both:

(a) Demand side constraints – investors are sceptical towards assuming the unsecured credit risk of smaller entities which may not have easily available and public financial information. Further, some of the more sophisticated investors like insurers and pension funds are restricted by regulation in the kind of risk they can hold in their balance sheets.

(b) Supply side constraints – perception of increased disclosure norms and requirements to get ratings from credit rating agencies, as opposed to the apparent ease of bilateral negotiations with to one or two lenders to get an unsecured loan.

Well-functioning bond markets do indeed require issuers to provide better financial transparency, but at the same time, help them diversify into various other sources of funding, thereby providing them access to a larger pool of money which they could use for growth & investment.

Some of the key issues in the development of debt markets (corporate/muni) in India are as follows:

(1) Law & regulations – under the RBI prescribed statutory liquidity ratio (SLR), banks are required to hold 21.5% of their liabilities in gold, cash and government securities, with similar restrictions under the IRDA prescribed Investment Mandate Regulations for insurance firms which need to hold a large proportion of their assets in ‘mandated investments’ like public sector bonds. This restricts their demand for corporate/muni bond issues. Hence, we see market demand only for government / quasi-government / public sector issues – and consequently the Indian bond market gets crowded out by PSE/government issues (like Rural Electrification Corporation of India, Indian Railways, etc.)

(2) Liquidity – most of the bond issues in India are private placements, i.e. a pre-decided list of a handful of investors/buyers are lined up for the bond issue, and who many-a-time have a say in the structuring of various covenants, leading to bespoke terms and lack of a secondary market (liquidity) for trading. That further leads to the absence of a refinancing and secured financing (repo) market for such bonds, which are primarily driven by bond liquidity. The universe of bond issuers & bond investors are thereby restricted to banks/FIs. And consequently, these bonds keep changing hands only between those 20-30 major participants, which heighten barriers to entry for other potential retail investors.

(3) Transparency – issuers of bonds need to be able to provide clear and transparent regular investor reports detailing their performance and usage of funds. While this may be slightly easier for corporates (who have such requirements built in to their internal systems for their equity investors), this becomes a big challenge for municipal bond issuances, which require the local governments to clean up their balance sheets.

(4) Limited product knowledge – due to the absence of sufficient market information, risk appetite for corporate and municipal bonds is limited among individuals and retail investors, and this adds to their risk-averse behaviour.

(5) Absence of adequate risk management instruments – international bond markets have well-developed derivative and swap markets to complement them. These provide the investors the ability to hedge the inherent interest rate risk and credit risk associated with these instruments, giving freedom to the investors to increase their risk tolerance limits and diversify their investments. Derivative products in India are very limited in scope, and methods to hedge credit risk are virtually non-existent, as a result money is poured into largely ‘risk-free’ investments like bank fixed deposits, and government-guaranteed bond issuances.

These problems are not insurmountable, but need immediate and active steps to be taken to address them. Addressing hurdles around corporate/municipal bond markets will have tremendous positive knock-on effects for the wider financing economy. Especially with financial inclusion high on the government agenda and new banks opening up their services to rural areas, debt financing and related liquid secondary markets would be a very healthy way to circulate credit across the Indian and global economy.

Why the RBI alone cannot fight inflation in India?

Inflation or change in prices is largely driven by two factors – demand & supply. And consequently, we have two kinds of inflation – demand-pull & supply-push. The most direct way in which a central bank may fight inflation is by moving around the “central bank rates”, thereby addressing the demand-pull kind of inflation. How does a central bank achieve this? One of the key tools at the disposal of the RBI is the liquidity adjustment facility (LAF) via the repo rate or policy rate (the rate at which banks can borrow money from the RBI, currently at 8%). The central bank periodically reviews this rate, and directly impacts the cost of money available to all the banks within the country. An increase in repo rate leads to an increase in cost of capital for banks – who, in order to continue making the same kind of profits, consequently increase the rate at which they lend money to borrowers, companies and the larger economy. These higher costs lead to lesser demand for money, lesser borrowing, and consequently lesser money in the hands of the people.

Further, the central bank could increase the cash reserve ratio (CRR) which, via the money multiplier effect, can have knock-on effects on restricting the overall money supply in the economy. Such reduction in money supply as well as a consequent decrease in overall demand helps achieve the objective of fighting “demand-pull” inflation. Some of the other monetary policy tools, towards achieving a similar effect, at the RBI’s disposal are the statutory liquidity ratio (SLR) – a directive to banks to invest a percentage (currently at 22%) of all their deposits in government securities, the marginal standing facility (MSF) – currently at 9%, which is a corollary of the repo rate, and open market operations (OMO) – direct market intervention by buying/selling government securities.

However, such monetary policy changes in India unfortunately do not have as direct and immediate an impact on money supply in the Indian economy – as compared to more advanced economies like Europe and the US. Reasons are manifold. Financial markets in India are still very nascent. Product penetration and financial inclusion are abysmally low. Almost 60% of the 1.25 billion population does not have access to basic banking services. Even among the 40% who do access banks, financial product knowledge is limited. Risk taking is limited, and a large part of this 40% are inherently risk averse, especially senior citizens and middle class families. Consequently, a large part of the savings of this population is invested in relatively “risk free” bank fixed deposits, or simply parked in savings accounts at banks. These in turn become a much larger source of money, as compared to the RBI, for banks in India. Given this, rate changes by the RBI do not immediately impact the money supply for Indian banks, and do not necessarily mean the Indian banks will immediately reflect those RBI rate changes in their deposit and lending rates. And the relatively poor 60% of the population who can’t access banks form part of the unorganised sector, “India UnIncorporated” as some may call, and rely on small time moneylenders who charge loan rates in excess of 30% – almost a parallel economy to that controlled by the RBI.

Compare this scenario with the more advanced economies – where the more developed financial markets provide people with numerous other “educated” investment opportunities outside of plain bank deposits, which consequently means, the central banks in those economies are a far bigger source of money for the banks in that country. As a result, central bank rate changes in the more advanced economies can have quicker and more direct effects on money supply, as compared to India and the RBI. Gist of the matter for India – with such a big parallel economy, restricted options for investment and under-developed financial markets, how can we expect RBI’s monetary policy alone to fight inflation?

What is more urgently required in India, which is facing a problem of moderate growth and still relatively high inflation, is a method to fight the “supply-push” kind of inflation. Prices rise not just because of increased demand, but also because of restricted supply – the kind we see in the Indian housing market (with far more potential for housebuilding to house the millions of homeless) or the kind we see in the Indian food market (with hoarding of goods to artificially distort the market), to take couple of examples. These two by themselves account for 49.7% and 9.8% respectively, i.e. about 60% of a typical Indian consumer basket – as described in the CPI index calculation. Factors like these are mostly outside the RBI’s control via monetary policy, and are better impacted by strong, clear and transparent decision-making and implementation by the Government, more under the realm of fiscal policy. Concepts like minimum support prices, the 3F subsidies (food, fuel & fertilisers), minimum wages, constrictive labour and land acquisition laws – all have an effect of creating an artificial impression of the market and masking the inflation beast under more and more layers of government discretion and control, and these need to be done away with. Further, we also need to urgently do away with the many “protectionist” government policies which discourage competition in various sectors of the economy, depriving consumers of better quality product at lower prices. Such policy moves will not only help combat inflation from a non-monetary policy perspective, but also foster a sense of belief among the citizens in individual rights, freedoms, government transparency and free markets. The current NDA government which has been elected with absolute majority, has the power to take concrete steps towards the above – without disruptive political allies throwing a spanner in the works.

India can truly benefit with this majority government and the central bank working in close cooperation with matched objectives – we just need to step up the rhetoric and action on the above.

How the state of the current global macro-economy doesn’t warrant a rate cut in India

There’s been a lot of clamour lately with the government of India and market participants suggesting that the RBI should be cutting its policy rate in order to provide a growth stimulus to the Indian economy. This seems too myopic a view to me. Firstly, in a ‘financially unstructured’ country like India, with a large shadow economy, demand gets only moderately impacted by the central bank cutting rates . Second and more important, the large amount of supply side constraints will constantly force up inflation, whatever be the RBI policy rate, and these constraints need to be addressed with immediate urgency. Third, there are the more technical factors like the inflation base effect, which has driven the inflation numbers down in the last 3-4 months (and probably will do so in Nov’14 as well), but then will quickly turn to drive the numbers up in Dec’14 and into Q1 2015. All these ‘domestic’ points are understandably holding the RBI back from cutting the policy rate.

Further, looking at this from a global macro perspective, India is increasingly being seen as a favourite among global investors – mostly through the foreign institutional investors’ route. In search for higher yields, these investors continue to flock to Indian markets, and consequently demand for Indian financial assets can still be considered to be on the higher side. India is definitely one of the leading emerging market economies of the world today, but of course, this is volatile money, and can easily go in and out of the economy depending on various market-driven factors. Let’s look at some of these external factors.

In the United States, analysts anticipate the Federal Reserve to hike rates sometime before mid 2015, although no clear statement is out on this from the Fed yet. Financial markets are preparing themselves for this event, which might lead to a flight of capital from perceived riskier and emerging markets like India. A lot of this probable move though seems already priced in to the markets, and the Indian economy might just even consider itself robust enough for the currency and overall demand to not get massively impacted by the Fed’s rate hike decision. But there are other factors adding to the uncertainty.

In the Middle East, OPEC has indicated no intention to cut the oil supply. And consequently, global oil prices have been plummeting over the last few months, stoking deflation fears in many countries. People are generally viewing this as reason for cheer, since the International Monetary Fund (IMF) estimates that a 30% decline in oil prices would improve growth by 0.8% in most advanced economies. And oil prices are down more than that – about 40% since 30 June 2014. With OPEC’s clear indications to stay their current course, there surely seems more room to go for this oil price slide, which will further suppress prices globally.

In Europe, despite subsequent rate cuts by the European Central Bank (ECB), investors’ expectations for future inflation have been falling in most of the leading economies. In Germany, bond market prices suggest annual inflation will be only 0.26% over the next five years, down from 0.8% at the end of June. With inflation still well below its target, the ECB has stepped up its rhetoric in the last few months on a massive round of quantitative easing (QE) and money printing. In Asia, Japan has been worrying about their declining GDP and a fall into a deflationary spiral, and as of the end of Oct’14, the Bank of Japan (BoJ) significantly ratcheted up its own quantitative easing program, with an intention to increase the BoJ balance sheet by 15% of GDP per year. So much money coming into the markets. The other big Asian giant, China, cut its central bank rates in Nov’14, again from the perspective of stimulating the Chinese economy.

Summary being, in the face of falling inflation and suppressed growth in many of the big economies, these countries are pursuing extremely dovish monetary policies, and are flooding the market with so much cash – which will desperately look for or already be looking for a home. Many of these policy moves have already happened or are imminent, and when executed, where do we think all this money is going to flow into? Investors are forever greedy, and in the hunt for increasing yields, this money is going to come pouring into emerging economies like India – driving up demand, and thus driving up prices. Interest rates that are under RBI control can only partially address, as mentioned above, this same demand side of the inflation equation. And given demand is only going to go up with such global shocks, India seems better placed to stay put on the RBI rates front and work harder to tackle supply-side constraints, in our constant efforts to fight this beast called inflation.

On direct cash transfers & financial inclusion

Direct cash transfers, which were initiated by the previous UPA government and are being furthered by the current NDA government, are gaining increasing significance in the Indian economy today. In my opinion, this step is the cleanest way of providing any form of social welfare to the large part of the population which is heavily dependent on state subsidies. Of course, the precursor to this is for those poor beneficiaries to have a bank account to receive these cash subsidies, and to possess the know-how to operate those accounts. And towards this, the government’s financial inclusion program via the PM Jan Dhan Yojna is indeed taking some concrete steps.

To put things in perspective, the total subsidy bill of the Indian government as per reported 2013-14 figures amounts to about INR 260,000 crores, or approx 2.25% of the GDP. This might seem a small proportion of the overall government expenditure to start with, but is increasingly a matter of public debate, given the method of delivery of these subsidies. Unfortunately, a large portion of the subsidy, intended for welfare of the economically less-abled, does not reach the end user on account of a large and inefficient public distribution system. As per research conducted by the Department of Earth Sciences at Uppsala University in Sweden – “Pilferage and leakages at both central and local levels have been huge concerns in proper delivery of food grain. In 1999-2000, around 10 per cent of rice and almost 49 per cent of wheat allotted for the PDS have been diverted. Between 1999 and 2005, the leakages from the PDS at the all India level increased from 24 per cent to 54 per cent. In 2007-08, the overall diversion of the PDS grains was 44 per cent. States like Bihar and Punjab have witnessed abnormal leakage, i.e. more than 75 per cent, while states like Haryana, Pradesh and Uttar Pradesh have high leakage, i.e. between 50 to 75 per cent. Tamil Nadu, along with other states like Andhra Pradesh, Kerala, Tamil Nadu, Orissa and West Bengal, has less than 25 per cent leakage.”

Gist of the matter is – a public distribution system involving physical transfer of goods across locations, a large chain of middlemen, and lack of appropriate systems to monitor delivery will always remain an inefficient form of subsidy provision, and as is seen in India, will be characterised by massive corruption and leakages.

The government needs to take the following steps towards effectively implementing the dual objective of subsidy transfer to the targeted recipients and financial inclusion:
1)      Firstly, ensure the quantum of direct cash subsidies serves as a substitute, and not an addition to the already existing set of subsidies, which will then become a huge financial burden for the exchequer to bear. The driving motto behind DTC should be:
– Primarily, giving cash in the hands of individuals to make the choices/decisions best suited for themselves
– Secondly, a gradual reduction, spanning few years, in the subsidy bill towards strengthening the government’s financial position
– Plugging leaks in the public distribution system

2)      Initiate pilot projects, as a parallel implementation of the PM Jan Dhan Yojna, whereby cash is directly transferred to the bank accounts of the recipients of the subsidies. No doubt there have been such projects undertaken in the past (http://bit.ly/DTCPilots), and problems have been found in those. But the benefits and impact of these have neither been adequately studied, nor have steps been taken to correct problems where they were noted. Further, given DTC will completely revolutionise the subsidy transfer method, the government needs to step up communication and publicity on this matter, as well as consistently track and make improvements to these pilot projects.

3)      Educate the poor, constantly, about the benefits of these bank accounts, along with the large scale initiation of them via JDY. The subsidy recipients need to be educated on the incentives these create, and how direct cash transfer gives them the freedom to choose their bundle of goods, as per their individual needs. This will then truly qualify as financial inclusion. Towards this, we need increasing investment in human capital, by way of citizens serving as teachers and business correspondents at the respective locations. The government needs to create an incentive structure in order to attract private enterprise and high quality talent to serve as leaders for such projects.

4)      Tie all of the above to the tax structure. Bringing every Indian citizen under the tax regime is obviously of primary importance to the government. This should include all these “new entrants” as well, for which the Finance Ministry and tax authorities need to work in conjunction with the PM JDY project leads. This could gradually also lead the way for the government to consider a regime of negative income tax, i.e. a system whereby the direct cash transfer subsidy effectively becomes a “tax payment” from the government to the citizen. Negative income tax (NIT) has been widely spoken about, and is an income tax system where people earning below a certain amount receive supplemental pay from the government instead of paying taxes to the government. Thereby, people earning a certain income level would owe no taxes; those earning more than that would pay a proportion of their income above that level; and those below that level would receive a payment of a proportion of their shortfall, being the amount by which their income falls below the “desired” level – which is effectively the direct cash transfer subsidy. Implementing the NIT via the existing tax mechanism will also enable the government target the subsidies more effectively, i.e. provide them to only those citizens who are not economically as “well-off”, as well as track the effectiveness of this subsidy over time. Of course, the NIT still has the problem of creating perverse incentives, in that it would make the recipient constantly dependent on the cash flow – but again, the NIT seems like the “best bad way” of systematically delivering social welfare to a targeted population.

Narendra Modi addresses rally in Arunachal Pradesh

Narendra Modi addresses rally in Arunachal Pradesh – click here for the NDTV story

This is the kind of stuff that heads of state should be made of – with a vision and action plan for strong defence of our national border. Would love to see a Prime Minister frequently addressing rallies of this form, even post appointment – after all, what is a government’s job apart from providing internal and international security, and reinforcing that sense through frequent public addresses.

All requirements for reservation, special status for states/sects will vanish once this sense of national sovereignty and oneness within India gets ingrained in the citizens.