India has a bank-based financial architecture. In the belief that India’s growth requirements necessitate a market-based financial architecture, the government has been eager to develop a corporate bond
market to force a transition to a market-based system. While such a belief is questionable since neither Germany nor Japan needed a corporate bond
market to fuel development, the forced development of a corporate bond
market has predictably run into several market hurdles.
In a highly informative RBI paper titled “India’s Corporate Bond Market-Issues in Market Microstructure”, Shromona Ganguly provides significant insight in to the state of India’s nascent bond markets. Liquidity is shallow, a majority of the bond sales are through the private placement route; old, established and high rated firms in the financial and infrastructure sector dominate issuances and secondary market trading activity and a large majority of bonds outstanding are short- to medium-term (two to five years) in tenure.
To surmount these issues, the government has considered several predictably high handed options. These include giving regulatory recognition to low rated debt, nudging corporations to access at least 25 per cent of their debt funding through bond markets and employing a credit enhancement guarantee fund to facilitate low rated issuances. These measures carry a significant amount of risk. The savings and loans crisis of the 1980s precipitated by “junk bonds” should serve as a warning against giving regulatory recognition to low-rated debt.
Similarly, forcing firms to access 25 per cent of their debt capital from an illiquid market will raise the cost of their funding and will compel them to forgo otherwise positive NPV projects thereby depressing investment. Lastly, the 'starring' role that firms offering credit enhancement such as Freddie Mac, AIG and MBIA played in the crisis of 2008 casts significant doubt on the sensibility of using a credit enhancement guarantee fund to jump-start corporate bond markets in India.
What the government needs to realise is that markets develop organically and they cannot be synthesised in a petri dish with artificial albeit strong stimuli. The two most important nutrients for the development of markets are information and institutions. Any debt contract suffers from a moral hazard problem. This arises from the information asymmetry (in favour of the borrower) between the lender and the borrower. The banks play a critical role in ameliorating this information asymmetry through monitoring. Theoretically, banks are supposed to have superior information about the borrower and greater access to the inner workings of its business compared to an average investor in the market.
Needless to say the information asymmetry between borrowers and lenders in India is much wider than in developed countries. This immensely amplifies the moral hazard problem. As the recent fiasco (among many others) involving PNB and Bhushan Steel shows, Indian banks have time and again failed miserably in their monitoring role. The question arises is that when a large established bank with immense resources cannot monitor and control moral hazard in lending to crooked Indian businessmen, why will an individual investor in an atomistic market lend to Indian businesses unless they are large, well-established and highly rated. This is exactly why the development of the Indian corporate bond market is skewed.
The reason we don’t see low-rated issues from smaller, younger, non-financial firms in the Indian bond market is not because of lack of supply as the government believes but because of the lack of demand. Investors don’t trust these issuers and do not have enough information to ex-ante evaluate good issuers from bad.
The second ingredient for the successful development of markets is institutional integrity. In a comprehensive cross country study, Ross Levine and Asli Demirgüç-Kunt (Financial Structure and Economic Growth — A Cross Country Comparison of Banks, Markets and Development, MIT Press, 2001) show that market-based financial systems develop in countries that have strong protections for minority and small investors, good and robust accounting systems, efficient legal processes and low levels of corruption. In other words, market-based systems develop in countries that have high institutional protection for investors.
As India lags significantly in all these areas potential investors in the corporate bond market demur at the prospect of assuming the risk that the lack of institutional protection exposes them to in fractured bond markets, forcing firms to seek funds from banks. Once again, the stunted development of Indian bond markets is rooted in structural issues with the Indian economy
and not the structure of markets.
In sum, while transitioning to a market-based system is a commendable goal with many benefits, such a transition cannot be forced on an economy that is structurally devoid of institutions and mechanisms required to support free and functioning debt markets. Instead of synthesising bond markets with steroids loaded with economically distortive incentives, the government should invest its energies in tightening legal, accounting, regulatory, disclosure and governance standards and watch the corporate bond market bloom on its own.
The author is a “probabilist” who researches and writes on behavioral finance and economics