What Indian debt market can learn from other emerging economies?

In a market defining move last month, Chinese Central Bank allowed the use of financial products that can potentially safeguard investors’ interest in the event of default of an underlying asset. In other words, the Credit Default Swaps (CDS) can now be legally traded on the Chinese bourses. This move comes amidst increased stress around the Chinese banking system, owing to exponential rise of public and private sector debt. As this debt mounts, and defaults rise to an unprecedented U.S. $4bn, this move signals the increased willingness of the Chinese government to let market forces deal with underlying defaults. It is noteworthy that in the wake of the 2008 credit crisis, China had introduced a lesser cousin of the CDS called Credit Risk Mitigation Agreement (CRMA), but the market never took off, largely because the state kept bailing out insolvent companies instead of letting them default, in the interests of financial and social stability.

India’s has had its share of frustrations with the growth of the corporate bond market – despite availability of instruments for investor risk hedging the debt market has failed to pick up. So really then, does the availability of hedging options like CDS drive an upswing in the investor sentiment by lowering riskiness of debt? If so, why hasn’t the debt market responded well in India, and why, despite having a robust corporate debt market, the CRMA market did not pick up in China? What is different this time around that China is expecting to achieve this time with CDS what it couldn’t with CRMA? It will be interesting to observe why such seemingly brilliant market moves have failed to gather mass in both India and China in the past. And what can India learn from this.

The Indian debt market
To predict the emergence of CDS market in China and possibly draw learnings for India, it is interesting to follow the journey of similar products in comparable emerging markets. In India, the second largest growth market in the world currently, CDS was launched in mid-2011 keeping in view a then Rs 10 lakh crore corporate bond market signaling a huge potential for the development of a market for CDS. India’s rapid population growth needed (and still needs) significant investments in infrastructure. These needs were, and still continue to be, sufficed by either FIIs or bank financing, with money market instruments such as commercial papers and CDS providing short term funds only. The system desperately needed an efficient and vibrant corporate bond market for facilitating the financing needs of infrastructure projects. A provision of hedging the credit risk of the investors in the infrastructure sector could give a much-needed boost to the FIIs as investors. While RBI introduced two new instruments – Repo and CDS – it was expected that the corporate bond market would start booming, auguring well for the long term funding especially for infrastructure development in the country. But five years hence, the CDS market has turned out to be a stillborn. The development of the debt market is constrained by highly conservative and slow moving financial markets reform. Despite repeated policy changes introduced by RBI to push their usage, the corporate bond market has grown just 6.43% points in the last 5 years; the corresponding CDS growth is at best puny.

Learning from other emerging economies
Among other emerging nations, Brazil and Mexico have seen a robust growth in their bond markets after they focused efforts on improving their fiscal environment and macroeconomic factors. What is common across these economies is that the governments have put in place structured programs to rein inflation, open up the economies, provide stable fiscal program and set up a regulatory and governance framework. Closer home in Asia, South Korea and Malaysia have the strongest debt markets in Asia with Korea’s corporate bond market penetration of ~77% as compared to India’s ~16%. This, when Korea’s GDP is very similar to India’s. In stark contrast, Philippines have a much volatile economy and the corporate bond market is still underdeveloped and heavily dependent on government support.

So is CDS likely to succeed in China?
In the past, why China’s earlier experiment with CRMA failed was that every time a corporate bond tended to default, the Chinese government interfered to restructure debt and orchestrate a bail out, making investors very nervous in the process, and reducing the government’s ability to continue such act over a sustainably long period of time.

The corporate bond market in China has seen a surge in the last 2 years, largely due to easing of restrictions on bond issuance, corporate debt becoming cheaper, and government’s intervention in corporate debt restructuring. With this growth has come the risk of defaults, as not all issuers are now backed by a state guarantee. In the last two years, default rates have risen in line with overall growth in corporate debt. Many FIIs remain apprehensive of investing in the Chinese market, and the higher default rates have caused the bond market to become more expensive. At this point, the introduction of CDS can be a market defining move if the government lets market forces play out rather than repeating past mistakes of interference.

The name is Bond!
India’s need for investments in core sectors like infrastructure and education over the next two decades will far surpass the ability of equity markets to finance these needs. Eventually, corporate debt will need to play a larger role than it does today. Just having the right instruments like CDS will not provide the much needed impetus for growth of debt market in India; a look at rival China and other economies like Malaysia, Brazil, Mexico and Philippines teaches us many important lessons in what our next steps should be.

A slew of measures have been taken in the last 2 years to allow the Indian debt market to open up further. The primary shift in investor sentiment has come from the central government being led by a party that could garner majority votes after nearly two decades of hung parliament and indecisive leadership. This government has been able to shift focus to growth, and drive some key reforms. Alongside, many fiscal and economic policy decisions by the RBI are pushing economic reform one step further. Large investors like EPFO being allowed to invest in corporate debt, issuers being permitted to consolidate and reissue corporate debt, and FPI investments being allowed in corporate debt are all moves in the right direction. The government has also done a good job at reining in inflation and putting growth back in focus. As a next step, the country needs to learn from global best practices and invest in providing better settlement and reporting platforms, focus on investor education to invite broad based retail participation, and continue down the path of fiscal reform and providing impetus to securitization market. In the absence of a strong debt market, it is unlikely that the Indian banking sector could come true to providing the much needed boost for infrastructure development in this growth hungry economy.

(About the Author: This article has been contributed by Poornima Vasdev, Director, Program Management, Sapient Global Markets.)