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Effect of Implementation of Reforms on the Bond Market. Its objective is to undertake quick and effective policy-oriented research backed by strong analytical and empirical basis, on subjects of current interest. The DRG studies are the outcome of collaborative efforts between experts from outside Reserve Bank of India and the pool of research talent within the Bank.
These studies are released for wider circulation with a view to generating constructive discussion among the professional economists and policy makers. Responsibility for the views expressed and for the accuracy of statements contained in the contributions rests with the author s. There is no objection to the material published herein being reproduced, provided an acknowledgement for the source is made.
We want to extend our thanks to Shri B. We are grateful especially to an anonymous referee and others who commented and provided feedback on the draft proposal, work-in progress and final seminar of this Study. I personally wanted to acknowledge Embry-Riddle Aeronautical University for supporting me with a grant of sabbatical leave to work on the Study. Finally, I wanted to thank all my graduate student assistants who helped me in the project.
In particular, I would like to thank Daniel, Kruthika, Lionel, Harish, Luis and Giby who were involved in the project at one time or the other. A well-developed capital market consists of equity and bond market. A deep and liquid bond market with a significant role of the corporate bond market segment is considered to be important for an efficient capital market. A vibrant corporate bond market ensures that funds flow towards productive investments and market forces exert competitive pressures on lending to the private sector.
While India boasts of a world-class equity market, its bond market is still relatively underdeveloped and is dominated by the Government bond market. The share of outstanding Government bonds in India was The share of corporate bond outstanding in India, however, was only 1. In this Study, we trace the reforms which have been put in place in the last decade and consequent developments of the corporate bond market in India. It is observed that though there is scope for further improvements in certain areas, such as reforming the stamp duty, substantial developments have taken place in the corporate bond market in India owing to measures taken by Securities Exchange Board of India SEBI , Reserve Bank of India RBI and the Government of India GoI in order to implement the recommendations of various committees on corporate bond market.
A study of the impact of the reform process on the corporate bond market shows that resources mobilised from the primary and secondary corporate bond markets have continued to increase over the years. The increase in the corporate bonds' outstanding amount, and as percentage share of GDP, indicated the gradual impact of the reform process in India.
One of the objectives of this Study is to analyse the experience of other emerging and developing economies EDEs at similar stage of development to capture lessons in relation to the development of Indian corporate bond market. In this milieu, we looked at the development of bond markets in Japan, Korea, Singapore, Malaysia and Brazil. The Japanese experience suggested that bond market development should be planned and implemented on a long-term basis with a reasonable sequence and should go hand in hand with economic development and banking reforms.
The Korean experience showed that Government policy reforms and development of a vibrant Government bond market was crucial for the development of the corporate bond market. Korean experiment and consequent failure with the Bond Guarantee scheme on the other hand had important implications for the development of the Indian corporate bond market. The development of the mutual fund industry in mobilising and channeling funds to the corporate bond market in Brazil and the growth of pension funds in supporting the bond market in Chile also had interesting implications for the development of the corporate bond market in India.
The issue of Sukuk bonds in Malaysia indicated that India could find innovative ways to improve the retail investor market. Finally, there were important lessons to be learnt from the reforms put in place in Singapore to improve the foreign investment in local currency bonds. Bond guarantees have not been successful in other countries such as Korea in developing the corporate bond market.
Bond guarantees in the long run could distort the risk return trade-off and would hinder the bond market from developing and acting as an effective alternate channel for raising resources. Further, the South Korean experience suggested that a financial crisis could trigger a collapse of the guarantee system. India might explore innovative ways, such as the issue of Sukuk bonds in the case of Malaysia, to attract retail investors. It is worth exploring such innovative ways to expand investors' base in the corporate bond market in India.
Another method to broaden the investor base is through advancement of the fund management industry by strengthening mutual fund offerings. Improvements in the retail investment sector of the mutual fund industry can help in enhancing the liquidity in the corporate bond markets. Investor base can be further strengthened by encouraging foreign investment in local currency bonds.
The GoI has closely monitored the developments in corporate bond market, revised the cap on foreign investment and the lock-in period from time to time to develop this market segment. Recently, the GoI reviewed and revised these limits and the lock-in period for investments. Previously, the lock in period of 3-year was perceived as a major hindrance in corporate bond market development in India. In order to increase foreign investor participation, India can follow the success of Singapore by easing regulations relating to disclosure requirements and give tax incentives to encourage foreign investments in local currency bonds.
The recent liberalisation in FII investment in long term corporate debt in the infrastructure sector by the GoI is a positive development and will help alleviate the original sin problem. Another way Indian Corporate Bond Market can be improved is through the development of credit enhancements such as securitisations and through collateralised bond obligations CBO or collateralised loan obligations CLO. Moreover, this requires independent credit analysis and credit ratings and better disclosure standards.
Though there are rating agencies in India with sound credit assessment capability and good track records, further efforts to create more credit rating agencies with due expertise will improve the credibility of ratings.
The Indian Government initiated reform measures to develop the corporate bond market and introduced prudent regulation and supervision.
The Government of India in January clarified the regulatory jurisdiction of different agencies, which facilitated for the smooth development of the corporate bond market by avoiding conflicts arising from involvement of multiple organisations in the regulation. According to the pecking order theory, profitable firms tend to finance through internal sources first and then external sources. Amongst external sources, companies tend to finance with debt or issue of corporate bonds first and then equity.
Analysis of trends in the sources of funds based on company finances studies of RBI on non-Government non-financial public limited companies for the period to show that companies in India tend not to follow the pecking order theory and have instead depended more on external sources rather than on internal sources. Amongst the external sources, bank loans seem to dominate the borrowings for these companies. For example, for the 5-year period , The share further increased to This shows that bank loans continue to be the major borrowing source for companies.
One of the reasons for the bank finance being preferred by corporations is due to the prevalence of the cash credit system in the banks in which the cash management of the corporations is actually done by the banks.
This indicates that the corporate bond market still has a long way to go before becoming a viable source for companies to finance their investments.
Literature suggests that corporate bond market yields would be more efficient than bank lending rates in reflecting the risk return trade off. For example, in a recent Reserve Bank working paper Mohanty et. Competition forced the banks to price loans out of alignment with the original intent of the BPLR to provide transparency. There is very little analytical work on the corporate bond market in India due to lack of reliable data on a longitudinal basis. Researchers, however, have worked with the data limitation to reach interesting conclusions.
We briefly surveyed available literature on the corporate bond market in India. Our analysis indicates that while the growth of the Government bond market has had positive influence on the development of the corporate bond market in India as in the case of other countries such as South Korea, the financing of Government deficit spending as reflected in the domestic credit extended by the banking sector has exerted a negative effect on its development.
Other factors such as the size of the economy, openness, size of the stock market and institutional factors like corruption have had little or no impact on the development of the corporate bond market. We conclude by noting that the reform process in the corporate bond market has been encouraging but the implementation of reforms has proceeded slowly. Companies continue to finance their investments via private placement and bank loans rather than through public issues and corporate bonds despite policies implemented to encourage retail and institutional participation, streamline the issuance process and create new and missing markets.
The objective of this study is twofold. First, it traces the development of the corporate bond market in India and second, it attempts to seek policy inputs based on the experience of other emerging markets in developing their corporate bond market. While the principal focus of the study is the corporate bond market developments in India, we also take into account the developments of the Government bond market and equity market in India in relation to the corporate bond market.
A sound bond market with a significant role played by the corporate bond market segment is considered to be important for an efficient capital market. The corporate bond market ensures that funds flow towards productive investments and market forces exert competitive pressures on lending to the private sector.
While India boasts of a world-class equity market, its bond market is still underdeveloped as compared to other Asian countries e. The Asian financial crisis of brought to the forefront the limitations of even a well-managed, regulated and supervised banking system in countries like Hong Kong and South Korea. The crisis clearly showed that banking systems cannot be the sole source of long-term investment in an economy. In this context, Jiang, Tang and Law point out that one of the principal benefits of a well-developed corporate bond market is to provide an effective alternative source of financing to bank financing.
Further, they list the following important advantages of bond financing over bank financing. Bank financing and corporate bonds deal differently with information asymmetries. While bond financing involves spreading credit risk over a large group of diverse bondholders, banks tend to minimise credit risks of borrowers and manage their risks by monitoring borrowers. Bank financing involves maturity transformation as liabilities of banks are typically short-term in nature and assets have longer maturities whereas in bond financing, investors are fully aware of the yields and time horizons of their investments.
Bond market provides a yield curve or a market-determined term structure of interest rates. The yield curve serves as a benchmark for pricing credit risk and other financial products. Bond financing lowers funding cost for high quality borrowers as intermediation costs are lower for bond financing than for bank financing.
A well-developed bond market introduces a healthy competition with the banking sector in providing corporate financing. Bond market allows pooling of risks through securitisation such as mortgage backed or asset-backed securities. A well-developed corporate bond market increases economic welfare as it complements other financial instruments and provides a full spectrum of investment vehicles whose payoffs across contingencies or states of nature cannot be easily replicated by other securities in the market for example, pension funds and insurance companies like to hold low risk debt instruments, with a stable income stream, which, in general, are not be provided by the equity market.
Bond market helps in spreading the risk among ultimate savers rather than get concentrated in the intermediaries. Luengnaruemitchai and Ong in their IMF working paper opine that core aspects such as benchmarking, corporate governance and disclosure, credit risk pricing, the availability of reliable trading systems, and development of hedging instruments are fundamental for improving the breadth and depth of corporate debt market.
Further, the authors note that the demand and supply of corporate bonds are dependent on factors such as the investor base - both domestic and foreign, and Government policies toward the issuance process and associated costs as well as the tax regime. Torre, Gozzi and Schmulker argue that there are two major approaches to develop capital markets, in general, in emerging markets.
The first one explains that the gap between expectations and observed outcomes is due to the combination of impatience with imperfect and incomplete reform efforts. This view argues that past reforms are mostly right, reforms needed in the future are essentially known, and that reforms have long gestation periods before producing visible results.
The second approach emphasizes on the right sequencing. This view claims that the gap is due to faulty reform sequencing where some reforms are implemented ahead of others, and argues establishing preconditions before fully liberalising domestic financial market and allowing free international capital mobility.
The study notes that intrinsic characteristics such as small size, lack of risk diversification opportunities, presence of weak currencies, and prevalence of systemic risk of developing countries limit the scope for developing deep domestic capital market in a context of international financial integration and that these limitations are difficult to overcome by the reform process. In other words, even if emerging economies carry out all the necessary reforms, they might not be able to develop their capital market to the extent of industrialised countries.
It seems, therefore, that the path emerging countries like India should follow is not unanimous. As a general rule, a gradual and complementary approach is beneficial, although in some cases, a given sequencing may be preferable. While countries like Australia have followed the sequencing approach by developing their debt markets before developing their bond market, others such as Latin American countries have developed their markets in conjunction with other markets.
In India, various committees viz.