The State of Capital Markets in India

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In this edition of The Interview, Fair Observer talks to Amit Singh, a partner at Allen & Overy.

As the Indian economy moves forward under the leadership of Prime Minister Narendra Modi, a lot of work lies ahead for capital markets. Even though the S&P BSE Sensex gained 5571.22 points (24.88%) for fiscal year (FY) 2015 that ended on March 31, investors were worried about the low corporate earnings that did not justify their earlier valuations. Global volatility has had an adverse impact on Indian equities, but other factors such as high corporate leverage, low credit growth and high bank non-performing assets (NPA) are to blame.

Nonetheless, multinational professional services firm Ernst & Young (EY) is optimistic about the initial public offering (IPO) sentiment going forward. With a number of private equity firms willing to realize their profits through sales, and favorable macroeconomic forecasts, it seems “the listing activity in India, Middle East and Africa exchanges are also looking optimistic for the rest of 2015.”

The debt capital markets have faced a number of problems, especially in the corporate debt market. According to research by Deutsche Bank AG, the size of the government bond market in 2006 was 40% of gross domestic product (GDP). This picture is bleak for corporate bonds considering that “nearly 90% of total domestic bonds outstanding [in 2006] are government issuances (i.e. Treasury bills, notes and bonds).” Research by Kanad Chaudhari, Meenal Raje and Charan Singh pointed out that the listed amount of corporate debt in 2011 was a paltry 2% of the GDP.

The reasons for a deficient corporate debt market in India are long, with some investors touting large fiscal deficits, poor rule of law and high statutory liquidity ratio (SLR) among other factors.

As with the corporate bond market, the securitization market has yet to develop in India. The Reserve Bank of India’s (RBI) “new priority sector norms” could be blamed for the 40% dip in loan securitization. Moody’s Investors Service affirmed that the government would do well to tap the securitization market for extra funding on infrastructure projects. Much is to be expected from India in the future, and the capital markets may need to revamp in order to realize the country’s enormous potential.

In this edition of The Interview, Fair Observer talks to Amit Singh, a partner at Allen & Overy, about Indian capital markets.

Daniel Currie: Which sectors/firms are looking to enter the equity and debt capital markets? Does it all have to do with the earnings of the specific economic sectors/firms?

Amit Singh: Let’s start with the debt capital markets. The biggest issuers of debt are Indian banks such as the State Bank of India, Bank of Baroda, Syndicate Bank and other public sector banks. For a long period of time, issuances from these banks constituted the majority of the debt issues from India; however, there has been a recent rise in the number of corporate issuers from India.

A lot of laws have stymied the development of the capital markets, and the withholding tax is a specific example. Issuers have to gross up for such tax deductions making the issuance expensive. There has been some positive development, and the withholding tax has recently been reduced for issuers in the infrastructure sector. Indian banks have been able to work around this–to some extent–by issuing debt through their overseas branches, while some corporations are issuing debt through overseas subsidiaries. However, this requirement has held back many corporates (especially those companies that do not have overseas subsidiaries or those companies that may not be able to utilize the money abroad).

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Another deterrent has been the Indian external commercial borrowing [ECB] guidelines as they impose a cap on the total amount that the issuers can pay.

On the equity side, the stock markets have not been doing well for a number of years, but this has picked up of late with the new government in power.

Currie: What are investors looking for when investing in equity and debt securities?

Singh: For equity investors, the amount invested depends on growth as you do not get the steady return from a debt investment. Equity investors are hoping their shares will rise in the future as companies grow and their prospects improve. Investors do  not care as much about receiving dividends which are, by definition, discretionary. As a debt investor, you are looking for capital conservation and prudence. You are not looking for growth as much as you are looking for a firm that can pay its interest payments on time.

It also depends on the investor’s risk appetite for yield. Highly rated companies that are in robust health can raise money in the debt capital markets at lower interest rates while others–such as sub investment grade companies–will have to pay higher yields.

Currie: How are capital markets affected by the monetary policy decisions from the US Federal Reserve/RBI?

Singh: Macroeconomic policies have a huge impact on capital markets–especially the international debt issuance from India. The current low interest regime has been a good time for debt issues from emerging economies as investors chase returns. The prospect of a rate hike by the US Federal Reserve later this year has also impacted the international debt markets, and particularly issuances from emerging economies.

Currie: Do firms and banks plan ahead on what to issue based on market forecasts?

Singh: Ultimately, there has to be a need from the issuer to issue debt, and the market environment determines if the debt can be raised at a reasonable price. Issuers certainly tend to factor in the market trend, which includes expected interest rate changes, when making their decisions.

Currie: With firms struggling with leverage and lower earnings, banks have curtailed their credit to corporations; this pattern is fueled by rising NPAs in banks. Do capital markets provide a good avenue for firms, or are investors skeptical as well?

Singh: There is some anxiety in the markets at the moment as public sector banks have suffered from high levels of NPAs. Having said that, there is still a lot of appetite for debt by such issuers as the current perception is that these banks are conservatively managed as they tend not to invest in exotic or speculative products.

Fair Observer - World News, Politics, Economics, Business and CultureCurrie: Research from Deutsche Bank reported that the high SLR is curtailing liquidity in the capital markets. Will reducing the SLR be a step toward the right direction, or is the RBI justified in keeping the level of risk as low as possible at the present time?

Singh: I certainly think the RBI can loosen its regulatory grip as the high SLR requirement stands in the way of secondary market liquidity, which is a key factor for the bond market.

Currie: Do you see a fundamental risk aversion of debt in the corporate sector? How can this be improved over time?

Singh: No, I do not think there is an aversion as a lot of corporates are issuing debt. Our law firm has advised Bharti Airtel, Indian Oil Corporation, Ballarpur Industries, Bharat Petroleum and other companies on international debt issues. These firms understand how market dynamics work, and are carefully calibrating their capital structure.

Currie: Deutsche Bank research in 2006 indicated the low liquidity in the corporate bond market, while a paper from the Indian Institute of Management confirms the same result in 2011. Why has it taken such a long time to build up the corporate bond market in India?

Singh: Many different things need to be done to create a better corporate bond market in India such as liberalizing interest rates and encouraging secondary market trading. There needs to be a transition from a pledge repo system to a classic repo system in the open markets, which is seen in the more mature markets. India needs to develop an interest rate and currency swap market, robust municipal bond market and create a clear taxation system. A whole host of things need to be done in order to bolster the corporate bond market.

It is still early days as India was a closed economy until 1991.

Currie: How does the slow legal system on contracts and restructuring affect the demand and supply for bonds in the capital market? What must be done in the legal and regulatory sphere to spur the corporate debt market?

Singh: Enforcing contracts is a huge problem in India. If you issue a bond outside India, then it is governed by either the English or New York law, with English or New York courts exercising jurisdiction.

However, once you get a judgment by an English or New York court, you still have to enforce it in India, and that’s where things have not quite worked out previously. Enforcement is difficult, if not impossible.

Currie: Securitization has increased over the period of time, yet it has not taken over. Moody’s has stated that the government can increase funding as a result of asset backed securities. Have you seen a growing appetite for these securities in the market? Does the market require certain economic conditions for securitization to take off?

Singh: Securitization of assets that originate in India remain largely restricted to traditional–domestic and foreign–bank investors who are looking to satisfy their priority sector lending targets; although recent changes made via the Union Budget 2013/2014 to the tax treatment of income distributed by the trustee have adversely impacted yields for banks. While mutual funds have also been traditional investors in these transactions, the inefficient tax structure has increased the level of uncertainty that has had an adverse impact on incentives to invest. It is not clear that the recent changes will deepen the securitization market by making it easier for certain institutions to act as trustee of relevant transactions; or whether the introduction of new codes of conduct for such trustee entities will be sufficient to overcome the disincentives to investing in securitizations.

A proper assessment of the measures required to grow the securitization market in India would require a comprehensive analysis of the current legal framework, economic conditions along with further research on market participant confidence levels.

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.

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