Indian Debt Market... Really?

CA YOGESH GUPTA

(Sr. Associate Analyst – ICRA Limited)

Dear Optimist, Pessimist and Realist. While you guys were arguing about the glass of water, I drank it.     

                                                                                                                            -Opportunist

Funny, isn’t it? While the Law Makers, Judiciary and we, the people, were busy arguing about the pathetic state of law and order in the country the banks seem to have sighted the opportunity in adversity and made a killing. Read on…

India has a very sophisticated and well-developed equity market -- comparable with the best in the world; however, the debt markets (Debt market refers to the financial market where investors buy and sell debt securities, mostly in the form of bonds) in India remain underdeveloped.  In fact, the secondary debt market in India is practically non-existent.

Reasons for Failure

Why has the debt market failed to develop in India?

Debt markets deal with fixed income securities that offer defined payoffs to investors over a defined time period. The risks inherent in debt markets are of two kinds -- credit risk or default risk and interest rate risk or duration risk.

Interest rate risk arises from changes in the opportunity cost of capital among various market participants between the time a fixed income security is issued and the time it is completely paid off. This is a risk that originates in the hands of the holder of the security (for the most part). If a country has an efficiently functioning market system, where trades are settled and where the clearing system ensures protection from default by individual market participants, this risk is handled well by the marketplace.

We do have a well-functioning government bond and securities market, primarily because it carries no credit risk and only carries interest rate risk (The Indian government routinely runs budget deficits of 3% to 5% and the shortfall is met through borrowing in the domestic government securities market). But, the corporate debt market (even for the highest rated corporates) has failed to take off. The reason the market has failed to take off has very little to do with the availability of capital or the existence of securities and market instruments. It has more to do with the feeble legal system in India and non-existence of strong bankruptcy, insolvency and receivership laws messed up further with sloppy implementation.

The corporate debt market deals with credit risk in addition to interest rate risk and it is in the case of the former that India is found wanting. What is the remedy?

Scenario in the U.S.

In a developed market like the U.S., if a company is unable to meet its debt obligations, it has to file for bankruptcy where all the equity is written down and where the residual assets are either liquidated or reorganized and allocated to different claims (societal, employee, crown and private debts) in their order of seniority. Although the process can be laborious, lengthy and prone to high accounting and legal fees, it works and follows the rule of law.

This is not the case in a market like India which is victim to orchestrated defaults/restructuring by corporates.

FCCB Shining!

During the 2006-07 frenzy, an interesting market called the foreign currency convertible bond (FCCB) market developed for Indian companies. These were bonds issued in foreign currency by Indian companies and sold offshore with embedded options for conversion to equity at predetermined premiums. In the go-go bull market of the time, investors lapped them up. For issuing companies, the benefit of lower interest rates on current debt with the potential conversion at a premium to equity at a future date seemed too good to let -go. FCCBs worth billions of dollars were issued by several Indian companies and absorbed by foreign investors.

As we know, the story got very interesting with the financial market collapse of 2008-2009. The financial market collapse of 2008-09 brought an unfortunate twist to the story and to the fate of the investors.


Stock values plummeted deep out of the money (in reference to the convertible option prices on the FCCBs) and the prices of the bonds themselves lost more than half their value.

Of course, crisis followed

During all of 2009, investors in the FCCB market remained in a state of panic. They eagerly negotiated settlements with issuing companies and many of the bonds were redeemed by companies (or bought back) at 50 to 60 cents on the dollar.

The problem is that Indian law and Indian courts do not accord sufficient sanctity to a private debt held by a private (non-bank) entity. The laws in India are enforced to almost exclusively protect the interest of banks that lend to private entities secured against collateral. In fact, until the securitization of collateral (SARFESI – Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest) act was passed in 2002, even a bank had to struggle through years of litigation before being able to enforce foreclosure on collateral offered against a defaulted loan. With the enactment of SARFESI, lenders secured by collateral (limited only to banks and recognized domestic financial institutions) could enforce their security interest on a defaulted loan without going through the judicial system.

How does the existence of a vibrant debt market benefit the U.S. economy and how does it harm the Indian economy? The entire Indian economy is dominated by the commercial banking system. The banking industry is dominated by government-owned banks (for a change!), which although very well run, are effective oligopolies. India is one of the few places left in the world where banks are able to earn net interest spreads of 3% to 4% on their loan books and are extremely profitable in their plain vanilla ‘deposit accepting - loan making’ business.

Taking a Toll

This has a huge toll on Indian companies (borrowers) and significantly reduces the efficiency of the economy along with high levels of systemic risk. With the exception of the 50 largest corporations in India that are large enough to be rated externally and borrow in foreign currency internationally, all Indian companies are dependent on the banking system for their debt financing requirements.

While Debt markets in India suffer from chronic neglect on the part of policy makers, despite the fact that there is clear evidence of fairly strong debt preference among households for their financial investment portfolio, the U.S. debt markets allocate capital very effectively and creditworthy borrowers are able to raise debt resources on very competitive terms. Even non-creditworthy and high-risk borrowers are able to raise resources (albeit at high cost) to enable them to undertake their high risk ventures (some of which eventually turn out to be among Fortune 500).

The developed and deep financial markets are therefore a vital asset to the U.S. economy. Unless the government in India is able to put in place the structural changes required to its legal and regulatory systems and ensure their effective implementation, its debt (and hence capital) markets will remain underdeveloped, placing its corporations at a disadvantage to those dwelling in economies with developed capital markets.


(All views expressed above does not belong to the Pro Edge 111 team, & are solely the opinion of the author)

Posted in: Economy, Readers Pick