Corporate Bond Market in India Essay

Foreword In the rush to produce pressing policy documents and brief notes that any government has to do, it is easy to let matters that whitethorn not be quite as urgent to go unat melt downed. However, the not-so-urgent often includes matters of great importance for the long-term come up- existence of the nation and its citizenry. Research papers on realiseics of strategic economic policy f each(prenominal) in this category. The sparing Division in the Department of Economic Affairs, Ministry of Finance, has initiated this Working Paper series to make acquirable to the Indian policymaker, as well as the faculty member and look community cha find outd in the Indian economy, papers that be based on research done in the Ministry of Finance and address matters that whitethorn or whitethorn not be of conterminous concern but address topics of importance for Indias sustained and inclusive maturation. It is hoped that this series will divine service as a forum that gives shape t o unused ideas and provides space to discuss, debate and disseminate them.Executive outlineIn this paper, we examine the factors behind underdevelopment of incarnate tie food trade in India. We assess that one of the major bottlenecks to the development of this merchandise lies in relatively vainglorious cost of funding which dissuade the firms to raise pay from this avenue. We argue that the miss of transpargonnce, inefficient commercialise do and il fluidity of the instrument not only lead to much(prenominal) extra costs of financing that hampers investment in the real sector but can hole the tie down paper certificate foodstuffplace in a measly level equilibrium. To alleviate such problems, we prescribe policies that look better production of information and incr alleviationd intensity level of transactions that will lessen both runniness and transparency problems and vouch efficient commercialize making. A combination of such policies include mandator y revealing of ratings by firms and assignment of multiple agencies for rating an discipline at different points of time, minimum surface of it of placements of (infrastructure) stick tos, establishing snag loss thres aim, among early(a)s will help breaking the noose and improve quality of issues and would eventually lead to a vibrant deposit market with stamp downd costs of financing investment.Structure of the paperThe paper is structure in three parts. The start-off part, section 3 and 4 dissect how corporations finance themselves and how does the incarnate bond market fetch in this work. Section 3 delves into how large Indian firms evolved in their financing prototype over the past decade. We further analyse what are some of the key drivers of such financing ideal when it comes to in corporeald bond markets in section 4. In section 5, we offer an analytical construct and humour that shows how liquidity, transparency and informational problems contribute not only to high(prenominal) costs of financing but may wee-wee 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 deem for the collective bond market to move from the catamenia state (of low level equilibrium) to a higher level equilibrium. We examine where the policy maker strength feature a role to play and where the market will respond to address its concerns spontaneously.2. A round of how large firms in India finance themselvesOur analysis rough(predicate) the debt market in India begins with a review more or less how firms in India finance themselves. Our information is necessarily restrict 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 bill data for financial firms. The sources and uses of funds statement, which is the first oddment of the balance sheet, yields important insights into the financing structure. bow 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 grammatical constituent Internal Retained Earnings Depreciation outside(a) New paleness Banks stay puts Foreign Current liabilitiesTable 1 shows the structure of the sources of funds, comparing the latest visible(prenominal) year (2010-11) against one decade ago (2000-01). The first feature of interest is native financing. We see a substantial credence on internal financing from 35.2% a decade ago to 30.8% straightaway. To the outcome that internal financing is important, it acts as a barrier against impertinently firms who do not have pre-existing cash-flow. The trademark of a sophisticated financial system is a substantial extent of external financing. From a normative point of view, to the extent that external financin g is greater, this is probable to induce superior resource allocation and competitiveness. bit to external financing, one important component fairness 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. unmatchable key element stock lending is 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 fifth in the global ranking by tot up 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 accounte d for only 3.9% of the sources of funds of large Indian companies. Finally, foreign borrowing rose sharply, from nearly postal code in 2000-01 to 3.2% in 2010-11. To some extent, borrowing foreign has served as a way for Indian firms to cut across 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 unbolted borrowing. The hallmark of a sophisticated debt market is the straw man of unbolted borrowing. Secured borrowing is the mainstay of a dewy-eyed 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 minusculeest quintile, in 2001, secured borrowings were at 76.7%. A decade later, on that point was a small decline, to 65.37%. This shows the stubborn domination of secured borrowing, when it comes to the smallest firms. interchangeable patterns are found in separate size quintiles also. In the fourth quintile from the 60th percentile to the eightieth 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 truly 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 functioningThe presence of corporate bond market in India is barely obvious 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 adjacent graph confirms inadequate growth of the bond market in India relative t o the countries like US, Japan and China.representative 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 single markets. The following summarise how the markets are different Intermediaries trade intermediaries in both bond and equity markets ensure liquidity. However the intermediaries in the bond market at present need to hold a bigger amount of capital than their counterparts in the equity markets because of the big batch of trade in each transaction. afterward the need to hold large inventory slip 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 riskinesss due to liquidity partly due to the absence of a supplementary market where retail investors can participate along with large players.Invest ors Bonds payoff are attractive to those who prefer predictable returns for known time horizons. As a result, bond market attracts institutional investors cautious of protect their principal e.g. pension funds, insurers, banks, etc. This also results in relatively risk averse retail investors unbidden to invest in the bond market. However, casual empiric 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 earliest 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 ex ample, it is well known that firms have a tendency to adopt excessive risky projects financed by debt due to limited liabilities. While banks can hold such activities by placing covenants, public debt holders are nerveless to do it because each owns an insignificant amount of the sum up debt. Many a times, the seniority of debt is debatable. On the other hand, the magnitude of the recoveries also depends on bankruptcy practice of law which in India is very weak.Hence, strong legal systems that hold open excessively risky activities and also ensure hot resolution of bankruptcy are also preconditions for the take of a strong bond market. Though thither might be a combination of factors that forget the growth of a vibrant corporate bond market in India, we will argue infra 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 at a lower place compactly sum marize 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 termsd 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 chief(a) 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 rabbet of the bond. Liquidity problems here refer to the ease of change the bond in a secondary market. Intermediaries advert both buy and sell side prices and hold inventory to enable market making. Any inefficiency in th is process will be automatically reflected in the pricing of bonds and thus will adversely propel costs of borrowing of the issuers.3.1 TransparencyThe 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 Right to rate the issuers of bond is not trammel 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 extra 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 meet criteria of worthy rating standards.