Why no corporate bond market?
Innumerable committees have opined on the reasons for the relative underdevelopment of India’s corporate bond market. However, despite several recommendations being implemented, there is still anaemic activity in existing corporate bonds, and anaemic issuance of new corporate bonds in relative terms. In addition, it appears that debt to equity ratios of Indian corporates have been falling steadily since the late 1990s, potentially a symptom of relative reductions in activity in the corporate debt market.
Is a corporate bond market necessary or important? Yes. Theoretically, such a venue will provide an important alternative source of funding for corporations, which will enable them to optimize capital structure in an environment of friction. Such a market should enable additional cash to fund operations or long-term expansion plans without diluting corporate control. So, in theory, corporations should welcome the development of corporate bonds.
The government should also welcome the development of the corporate bond market because it would spur corporate activity and thus economic growth. Finally, investors such as pension funds and insurance companies should welcome corporate bonds as an additional set of instruments in which to invest, providing, in theory, a better overall risk to reward trade-off since there would be more opportunities for diversification.
If this is such a good thing, why isn’t it happening?
One important fact might hold the clue to explaining the lack of growth of this market. That is the huge pile of corporate debt that is currently being held in the form of loans, especially by state-owned banks. This massive inventory of loans generates significant incentives for three parties—banks, corporations and the government—to delay or inhibit the development of a significant corporate bond market.
Consider banks. At present, banks are not required to mark loans that they make to corporations to market, but are, of course, required to mark corporate bond holdings to market. This obviously makes corporate loans more attractive than corporate bonds as it offers an opportunity for banks’ balance sheets to be shown healthier than they truly are. While this is an issue on its own, the more significant issue is the incentive effect that the existing pile of bad loans creates for banks.
Consider a bank sitting on a set of poor loans issued to companies. If corporate debt is traded for these companies, there are few incentives for banks (the primary information providers about these companies’ debt prices) to trade in the corporate debt market. This is because banks have the reverse incentive, to ensure that the price of their poor loans reflects as little information about the (true, bad) state of affairs. Moreover, if debt isn’t already traded for these companies, banks have a strong incentive to ensure that it is never issued—once again, to make sure that there is very little information in the public domain about the true scale of the bad loans problem.
Now, consider corporations. It goes without saying that large corporations with significant levels of unsustainable debt have no incentive to issue increased levels of debt, and indeed, have significant incentive to ensure the creation and perpetuation of information asymmetries that will inhibit liquidity in the market for their debt. So, the problem is not merely a problem of demand—from banks—but also extends to debt supply.
Finally, consider the government, which faces a trade-off. In the short run, enabling a vibrant corporate bond market will result in significant losses to the banking sector, especially for nationalized banks, which are significantly exposed to bad corporate loans. This is because better price discovery will reveal the full extent of the problem of non-performing assets resulting from exposure to over-leveraged corporates. It is also the case that there may be more corporate failures if the full scale of the bad loans problem is revealed to the world.
In an environment in which bankruptcy resolution continues to be difficult because of a poor legal environment and unclear rules, this may prolong the agony for the corporate sector, especially if there are problems that percolate up and down the supply chain. On the other hand, in the long run, cleaning the Augean stables of corporate loans should free up the lending environment, eventually resulting in the positive outcomes that committee after committee has highlighted as outcomes from a vibrant corporate bond market.
Governments, being governments, inevitably have incentives to choose the evergreening solution—electoral cycles are generally too short to tolerate the kind of short-run pain that will likely result from better price discovery. So, what is to be done?
One possibility is that the Reserve Bank of India could mandate that corporate loans should be marked to market in exactly the same fashion as corporate debt. Another is that the marking-to model be independently audited. A third is that the central bank can attempt to find ways to make corporate loans fungible with corporate debt. Having an independent regulatory organization with a broad mandate on this market might allow circumvention of what is essentially a political problem.
Will this (or anything) be done? It remains to be seen. An all-too-likely possibility is that we get yet another august committee opining hopelessly about a series of futile measures intended to generate the corporate bond market we so badly need, but may never get.
Tarun Ramadorai is professor of financial economics at the Saïd Business School, University of Oxford, and a member of the Oxford-Man Institute of Quantitative Finance.
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