Development of the Corporate Bond Market a Step in the Right Direction

Development of the Corporate Bond Market a Step in the Right Direction

Last month, Union Bank of India became the latest state controlled lender to be downgraded to junk by S&P. The pick-up in corporate performance, and the de-bottle necking of stressed sectors, in India is likely to be gradual, hurting Union Bank’s asset quality and similar is the story for many such banks in India.  The stress has pushed up the bank’s non-performing ratio of most banks in India and this has been a very large concern for the public markets on the whole as many investors wonder how much more trouble is really there for banks in India and puts a question mark on the overall asset quality of the banks in India.

Neither India’s economy nor its banks are in the greatest shape. Growth slowed from 7.9 per cent in the first quarter to 7.1 per cent in the second and according to the probably more accurate methodology the government used to employ, the first quarter figure was just over 4.3 per cent.

Fixed investment contracted more quickly, hardly surprising given that utilization of the economy’s current capacity remains low. It is just above 70 per cent overall, while in some industrial sectors such as steel and paper the figure is as low as 50 per cent and most companies struggling to survive and make ends meet for paying the interest to the respective lenders.

At the same time there had been a near full stop in bank lending to industry, as the banks have become very careful on the loan book and in being ultra conservative credit has become a big problem for most medium and small companies in certain cases being larger companies.  Without credit, economies cannot grow. However, for many sectors there is both little demand for bank credit and little supply, thanks to the combination of broken bank balance sheets and excess industrial capacity. Cost of capital, especially for bank borrowers, remains lofty far higher than almost anywhere else in emerging Asia.

But there are signs of a potential easing of the logjam. The Reserve Bank of India is introducing rules that should reinvigorate the corporate bond market, creating a less dependence on banks funding the next leg of the investment cycle. The development of the bond market will reduce pressure on the banks. This could be possibly the best last master stroke by the former RBI governor Dr. Rajan.

It could be that the RBI is pushing an open door. Banks, with their need for capital to fix balance sheets, have been reluctant to pass on any rate cuts to corporate customers. It is more attractive for companies to issue debt than bow down to their bankers.

To make sure that large companies turn to this alternative source of funds, the RBI is imposing higher capital charges and provisions for loans to bigger borrowers. To encourage smaller companies to access the market and to encourage investors to bet on them regulators raised the credit enhancement limit from 20 per cent of the bond size to 50 per cent.

Foreign investors will find it easier to hedge their rupee exposure something that has in the past been a big cap on their involvement in the local bond market.

The challenge always was the lack of depth and liquidity, as the turnover was less than $1bn a day.

Although these measures are incremental, they should ultimately make a difference when there is more basic demand for credit.

The promise for an Indian economy that has slowed does not end there. A significant swing factor is the monsoon it largely accounts for the difference between the worst and best economic cases. After two disappointing years the rains have been generous, giving rise to lower food prices. That should lift rural income, boosting consumption.

Meanwhile, to the extent that there will be a re-acceleration in economic growth, some of it may come from the government, as it ramps up spending to build desperately needed roads, upgrade decrepit railways the average speed of a freight train is 25kmh and improve ports.

The government has been a big part of the problem. Organisations such as the National Highway Authority would rather dispute than pay bills for work from the big infrastructure companies, contributing to both the physical and the financial logjam. As the corruption that gave rise to blockages and delays eases, fiscal spending will be more effective.

With inflation coming down and public spending less wasteful, the RBI can finally move more aggressively to cut rates and reduce borrowing costs. That is the proper sequence of actions a sequence from which other governments and central banks could learn as the cost of capital is far higher than almost anywhere else in emerging Asia

_Farzan Ghadially