Tamal Bandyopadhyay: Bringing life to debt

In the absence of active and liquid hedging tools, debt markets can never grow.

The sad truth is that investors in the corporate bond market do not enjoy the same access to information as a car buyer or a homebuyer or, dare I say, a fruit buyer.

Arthur Levitt, the longest serving chairman of the Securities and Exchange Commission, made this remark in 1998. Eight years down the line, the corporate bond market in the US has radically changed but the scene in India remains unchanged "" trading in the secondary market is extremely thin (97 per cent of trading comprises government paper) and most bonds are privately placed. As RH Patil, former managing director of National Stock Exchange and now the chairman of Clearing Corporation of India Ltd (CCIL), puts it, the corporate bond market is still in the stone age. Patil headed a high level expert committee on corporate bonds and securitisation which submitted its report last December and the Prime Minister's Office is now taking a close look at the report.

Indeed, just last week, the prime minister said, "Debt markets in India have not quite delivered on expectations" and then promised to make policy to make it "deeper, broader and more liquid."

Just how deep he needs to go can be seen from the fact that, in the US, the corporate bond market accounts for 22 per cent of the country's GDP. In Japan, it's 16 per cent and in the EU this is around 10 per cent "" for India, the figure's around 5 per cent. (In India, it is the government debt market which is large, accounting for 78 per cent of GDP, but this is not a real market as banks are captive investors thanks to the mandatory SLR).

The government bond market saw reform beginning in April 1997 when the practice of automatic monetisation of the government's budget deficit through ad hoc treasury bills was abolished with the introduction of a new scheme of called ways and means advances (WMA). Five years later, in August 2002, the Reserve Bank of India (RBI) spoke about the introduction of STRIPS (Separate Trading of Registered Interest and Principal of Securities), which allows debt market players to trade the interest and principal of a bond separately. But nothing has happened on this front as yet. The RBI's efforts on retailing of gilts has also not paid off since the yield on ten year paper is about 7.65 per cent while a one-year bank deposit fetches over 8 per cent. Short selling of government paper could give a boost to this market, and the RBI has recently allowed this, but positions cannot be carried forward the next day. This cannot add depth to the market.

The situation in the corporate bond market, which is just little over a decade old (against the century-old equity market) is even worse. Financial institutions, banks and public sector companies account for 80 per cent of the market. Most of the instruments are privately placed and illiquid since investors normally hold them up to their maturity. SEBI issued a directive in 2004 saying all secondary market trading of bonds should be on the automated order matching screen of stock exchanges. However, this has not enhanced the transparency in trading since most investors resort to bilateral deals which do not need to be reported to the exchanges as this saves them the bother of going through elaborate listing procedures (see table).

The Patil panel too is in favour of doing away with the elaborate listing procedures and it feels that the focus should be on rating of bonds. It also cites instances of high stamp duty on debt papers. Under Article 27 of Indian Stamp Act, a 0.375 per cent stamp duty is applicable to all debentures while promissory notes attract only 0.05 per cent.

While fixing such issues can improve the primary market for corporate bonds, the secondary market can be deepen only by setting up a credible trading platform. SEBI is in favour of Bombay Stock Exchange doing this job but Patil says you cannot leave the National Stock Exchange out of this. A larger presence of FIIs can also add depth to the market "" there is no cap on FII investment in equities but they cannot invest more than $1.5 billion in corporate debt.

Finally, the most critical factor about the Indian debt market is that it is a cash-only market. Both the forex and equity markets have derivatives but debt market does not have this. While credit derivatives do not even exist in the market, interest rate derivatives and futures made a brief appearance but vanished thereafter.

The reason behind the banking regulator's reluctance to push for derivative products could be the lack of clear regulatory structure in a multi-venue trading market. The RBI regulates banks while SEBI regulates brokers, mutual funds and stock exchanges. A 2002 report of the Asian Development Bank had said: "Sebi and the RBI must ensure the responsibilities for regulation and enforcement in the secondary markets result in consistent treatment of all trades irrespective of their origin. Ideally, all trading should be under a single, clear regulatory remit." Both the regulators should take initiatives to sort out the issues, if any. The banking system alone will not be able to support the India growth story, a robust corporate bond market is critical.