Developing a long-term bond market

In his recent address at the National Institute of Securities Markets, the Prime Minister underlined the importance of bond markets for infrastructure financing in India. He pointed out that currently all infrastructure financing is done either by the Government or World Bank loans or public sector banks.

The Prime Minister also noted that bond markets should enable long-term borrowing to provide viable long-term infrastructure financing.

In his closing remarks, he said that the absence of long-term bond markets is a problem that India’s financial community can solve, if they put their minds to it.

When the Prime Minister mentions India’s financial community, it is not clear if he includes the Government. Even excluding their borrowings for financing infrastructure, India’s government(s) are the biggest and most influential participants in the domestic bond markets — in whatever form they exist now.

They have borrowed and continue to borrow the largest amounts for the longest maturities (at lower and lower costs given their domineering presence). They also have a perennial borrowing presence in the markets.

Indeed, it seems odd to be talking about bond markets development without the sovereign’s role in it, as both a policymaker as well as a participant. Therefore, it is perfectly reasonable to include the Government within the term ‘financial community’. So, what can the Government do as part of the community to develop Indian bond markets?

An enormous amount of spade-work, it appears — at least, given the current state of Indian markets.

For a start, let us take the Prime Minister’s point that bond markets should enable long-term borrowing to provide viable infrastructure financing.

For somebody to borrow long ( on-lending to long-term projects), there should be some investor willing to lend monies for the long term. The investor should be incentivised — monetarily in yield terms — to lend long term relative to short-term lending and/or investment, to compensate for the significant risks he would be exposed to at the long end, namely, credit and inflation risks.

Again, is it not reasonable to presume that compared to short-term investments, long-term investments carry a much higher level of credit and inflation risks?

Now, who can borrow long from the markets and which investor would be willing to commit money for the long term when there is hardly any material differential between short-term yields and long-term yields?

That is, there is no specific compensation for the higher level of risks inherent in long-term investing. The investor is better off making short-term investments and rolling them over.

The borrower would then want long-term funds but the investor would have no incentive to lend long-term.

There is a perfect mismatch or disconnect here. In market parlance, this environment or state of affairs is termed as a flat yield curve environment — when there is a negligible differential between short- and long-term yields.

It is a complete disconnect between private borrowers and private lenders that Indian governments have created over the years in the financial environment through their perennial, overwhelming, financially repressive and market-distorting borrowing actions in the markets.

The point to note here is that this disconnect is not a recent development; it is a long-term structural weakness. How can private long-term financing markets develop then? The chart highlights the above phenomenon.

As noted , the flatness in the Indian bond yield curve is a long-term phenomenon. It hangs like an albatross over bond market development. Importantly, it also adversely impacts the development of the overall financial sector itself.

For instance, ever since the advent of private life insurance companies in 2000, there has been so much talk about how to channelise long-term insurance money into infrastructure financing.

But, given how the bond yield curve has developed in the past 15 years, which private life insurer would willingly invest for the long term when he can make the same investment returns at the short-end?

Only mandates and compulsions will force private long-term investors to invest long term in India’s bond market environment. That is what has happened as the IRDA’s investment regulations show.

The casualty, though, is the development of the insurance sector itself — amply evidenced by the significant slowdown in premium growth, a biased focus on short-term investment products through the ULIP mechanism, the resultant high volatility in overall business performance and all of it capped by a series of foreign investor exits from the Indian insurance market. When the Prime Minister talked of FDI having increased sharply in the past two years, one wonders if he factored in the long-term deceleration in insurance FDI.

The Prime Minister also wants the Indian municipal bond market to develop! When the foundation — which is the sovereign market — itself is so weak, this seems rhetorical, to say the least.

Overall, one hopes Indian governments accept that they have a fundamental role to play in setting the base of the bond market. They are a critical part of the ‘financial community’.

That can be best done if governments act purely as another market participant and do not use the power of ‘eminent domain’ (through the RBI) to distort the market’s credibility and its ability to function as a seamless financing mechanism.

That is difficult, to say the least. However, the Prime Minister says that his government will not shy away from taking difficult decisions, if those decisions are in the interest of the country.

If so, would the Government allow free play of the forces of demand and supply to determine the shape and level of the bond yield curve — without the market distorting role of the RBI as government debt manager? This will be metamorphic institutional reform.

The writer is a Chennai-based financial consultant