India’s credit to the private non-financial sector as a proportion of gross domestic product (GDP) peaked at 62% in 2013 and is currently around 58%. For China, the comparable number is 208%. Even as the credit-growth relationship remains far from linear, for faster development, credit disbursement has to increase. There are two broad ways to do it: through banking and non-banking channels. A lot has been done about the former, from governance tweaks to mergers and recapitalization, especially in the case of public sector banks. A lot still needs to be done. On the non-banking side, we have focused more on the shadow banking or non-banking financial company (NBFC) part: from providing liquidity backstops to encouraging co-origination of loans. All that is needed too.
But just directly trying to unclog banking and NBFC pipes is not enough to improve financial intermediation. India has been in the midst of a gargantuan but gradual shift from a partially East Asian and Continental Europe-style state banking model to a more Anglo-American style arm’s length model.
Our equity and equity derivatives market have been excellent for our per capita income. Our private retail-focused banks have been world-beaters in many ways too. What’s missing is longer term, non-consumer focused finance to fund our infrastructure, real estate and mid-level corporate needs; the smallest companies still have to rely on banks, while the largest are already relying on external commercial borrowings, or ECBs.
Given the severity of the current slowdown, it’s imperative to have a bond and quasi-bond market up and running quickly. In the US, you can buy dozens of liquid corporate debt exchange traded funds, or ETFs, sliced and diced by maturity, risk, sector and so on (an ETF is effectively a mutual fund (MF) that’s listed for trading at any time of the day). In India, the first corporate debt ETF has just been approved by the cabinet, and yes, it will focus on the debt of public sector units. That is progress, but we are far behind.
To compare our bond markets with the US would be unfair, but our equity markets are already punching above India’s economic weight, quibbles notwithstanding. The question to ask is why have our bond markets failed so far while equity markets have done much better? Many experts have detailed views on this, but let me summarize and surmise as follows:
First, our debt MFs get adversely taxed compared to equity MFs. Not only does long-term capital gains tax in debt kick in after three years instead of one, the short-term capital gains levy is at the recipient’s marginal income tax level, as opposed to 15% for equities.
Second, for dividends received via debt MFs, they are taxed at source at 30% plus cess/surcharge, irrespective of the recipient’s income; again, not only are equity MFs better treated, even bank deposits are more advantageous for lower-income recipients.
Third, there is lack of a sufficiently liquid electronic market for bond trading. Much work is being done on this, but even the Indian sovereign debt market is not particularly easy to access for retail investors and especially traders. To kick-start this, whatever incentives are needed must be given.
Fourth, there is also a lack of a proper bankruptcy procedure. However, after India adopted the Insolvency and Bankruptcy Code, and the Supreme Court recently ruled in favour of the rights of senior creditors, this should change. Still, we cannot afford complacency.
Fifth, unusually high inflation-adjusted fixed deposits and small savings rates, much of which the government can nudge down in coordination with the Reserve Bank of India. It is a political call, but it is tough because many are still anchored to nominal numbers. While inflation has come down from double-digits to low single-digits in recent years, real variables are yet to fully adjust. Scaremongering over the plight of senior citizens is easy.
Lastly, India’s absence from global bond—unlike equity—indices has taken away patient capital. Various holding limits need to be increased and the central bank’s conservatism needs to give way. Just as China issues dollar and euro sovereign bonds, India should too. But New Delhi decided to back off and killed a bond rally earlier this year.
Unfortunately, the present crisis has worsened and we may now need “quantitative easing" to bring the term premium down in India—aka the rate differential the government has to pay for longer-term borrowing. In India, 10-year yields are high compared to both the inflation target and short-term yields.
While we have suffered the short-term harm of inflation targeting—a much needed reform in my view—its longer term benefits are yet to materialize. As capital markets judge the credibility of our inflation promise, slower growth ironically worsens market perceptions of that resolve. “Big Bang" action on the macro-economic front, especially bond-currency-derivatives markets, is needed right now. This, together with incentives for infrastructure and real estate trusts, would enable massive private capital expenditure as demand recovers.
Harsh Gupta is the chief investment officer of Ashika Group