INDIAN CORPORATE BOND MARKET MOVING SLOWLY BUT STEADILY

UNCLAS SECTION 01 OF 04 MUMBAI 000238

SENSITIVE
SIPDIS

USTR FOR AADLER

E.O. 12958: N/A
TAGS: EINV EFIN ECON IN
SUBJECT: INDIAN CORPORATE BOND MARKET MOVING SLOWLY BUT STEADILY
FORWARD

MUMBAI 00000238 001.2 OF 004



1. (SBU) Summary: Since September 2008, the Indian corporate
bond market has witnessed an increase in trading volumes as
Indian companies found it difficult to raise money through other
routes. Both the Reserve Bank of India (RBI) and Securities and
Exchange Board of India (SEBI) have taken incremental steps to
increase market volumes. However, while primary issuances have
grown, trading of issued bonds in the secondary market continues
to lag behind. One reason for this is that many banks and asset
management companies tend to hold corporate bonds until
maturity, creating a lack of liquidity in the secondary market.
In addition, the requirement for banks to hold government
securities diverts funds away from the corporate bond market.
Overall, many small distortions and disincentives remain in the
system that discourage the development of a corporate bond
market. Since there is no one switch that can be turned on to
create a robust corporate bond market, regulatory tinkering will
likely continue for the near future. End Summary.



Regulators Hand in Hand to Develop Bond Markets

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2. (U) In 2009, the Ministry of Finance along with SEBI, the
capital market regulator, and the RBI, India's central bank and
banking regulator, have continued to take steps to stimulate the
corporate bond market. In January 2009, the Ministry of Finance
increased the cumulative debt investment limit from $6 billion
to $15 billion for foreign institutional investor (FII)
investments in corporate debt. On May 11, SEBI simplified the
listing procedures for debt securities in order to develop the
primary market for corporate bonds in India. Most trading in
this market is over-the-counter (OTC),as there is no formal
exchange traded platform yet. In the annual policy statement
released in April 2009, the RBI announced a new trade-by-trade
settlement process consistent with OTC activity. Interlocutors
mentioned that much of the work for exchange-based trading has
been done, including the establishment of corporate bond trading
platforms at the National Stock Exchange and Bombay Stock
Exchange. However, the RBI's announcement is an admission that
OTC activity will continue to dominate for the time being.




3. (SBU) Dhiren Mehta, Director of Emerging Markets at
Citibank, and Ashish Ghiya, the Managing Director of Derivuim
Capital believe the new FII limit of $15 billion is sufficient
to generate interest from the trading desks of foreign banks.
However Mehta estimated that FIIs would take almost a year to
hit this limit; since most FIIs buy bonds to hold until
maturity, the increase in volume would not spur increased use of
the secondary market. Jeevan Sonparote, who monitors FII
registration and participation at SEBI, expressed disappointment
with the pace the new limit was being utilized, especially since
SEBI has made it easy for corporations to issue corporate debt,
he said. For a company already listed on stock exchanges
seeking to offer debt securities, SEBI has reduced the amount of
information the company needs to disclose, and new guidelines
emphasized electronic disclosure to save on cost and time of
issue. However, Mehta described the new, shortened period --
three weeks -- as still too long, given that market conditions
can change drastically in three weeks.




4. (SBU) Looking ahead, many minor reforms await RBI action.
Both Mehta and Sonparote described the ability to lend, or
"repo," bond holdings to enhance returns awaits the RBI's
finalization of the clearance mechanism. Exchange-traded
interest rate derivatives should be announced in the next six
months, which will help bond holders separate out various forms
of risk. The RBI has also begun the process of introducing
"strips," where government bonds can have the principal and
interest payments traded separately. SEBI expects FIIs to be
allowed to participate in primary issuance within one-to-two
months, so they won't have to rely on miniscule secondary market
activity to acquire positions. Finally, Ministry of Finance
Director Gopal Nair expected the negotiations on harmonizing
state-imposed stamp duties to continue with the new government,
but progress is slow.

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Corporate Bond Market Volumes Picking up in the Primary Market

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5. (SBU) According to data from SEBI, listed companies have
raised about $42.27 billion of bond capital through private
placements of corporate bonds during April 08- March 09, a 1.6
times year-on-year increase. Media reports suggest that as more
companies find it difficult to access funds from issuing equity
and external avenues such as external commercial borrowings, the
corporate bond route has become more attractive. Mehta noted
extreme domestic liquidity, rather than a return to normally
functioning markets post-crisis, driving the demand side.
Sonparote remarked that although both the number of bond
issuances and the capital they raised have picked up, the growth
in the latter has not been significant. The growth in number of
issues is likely due to individual companies accessing the
market multiple times for smaller offerings. He thought that
these companies may not be able to raise a large amount in a
single debt offering. Ghiya indicated that despite continuous
reforms in the corporate bond market, volumes were not picking
up, as the regulator lacked an understanding of the market's
participants. He elaborated that when stock markets were
developed, SEBI focused on three classes of investors -- FIIs,
domestic institutions and retail investors. However, in the
corporate bond market, retail investors are insignificant, so
SEBI needs to focus on FIIs and domestic institutions and
increase their participation. To his disappointment, SEBI is
trying to replicate the same approach it took with the
development of equity markets in the corporate bond market.



Increase in Primary Bond Issuances Not Translating into Volumes
in the Secondary Market

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6. (U) While primary issuances have been growing, most of
these are by public sector financial institutions and issued on
a private placement basis to institutional investors. Ghiya
estimated that despite an annual issuance of about $9.5 billion
worth of corporate bonds by public sector undertakings (PSUs),
the most liquid segment, the daily trading turnover of the
secondary market was only about $21 million. The implication is
that it could take an uncomfortably long time to sell a large
bond holding if one wanted to exit the market. Mehta from
Citibank explained that bond markets are driven by liquidity,
regulation, and the investment needs of the different classes of
investors. He elaborated that each investor's risk appetite
varies due to their unique risk profile. Asset management
companies (AMCs),70 percent of whose assets are institutional
money, tend to invest in the shorter end of the bond market,
normally maturing in one to three years. For instance, Reliance
Mutual Fund has assets of about $20 billion under management; 75
percent of these assets must be in highly liquid investments
because they could be withdrawn on a one-to-two day notice. He
added that generally AMCs buy bonds to park excess cash and are
not necessarily making a strategic investment decision when they
buy corporate debt.




7. (U) In contrast, insurance companies tend to hold bonds of
maturities 10 years or longer, since they must manage longer
term assets and liabilities. The government-owned Life
Insurance Corporation, one of India's largest insurance
companies, has adopted a conservative style of investing and
holds 10-30 year bonds. Government- and privately-managed
provident and pension funds are also extremely conservative, due
to their purpose as retirement funds. Ghiya noted that
recently, retirement and pension funds had relaxed some of their
investment guidelines, but he believed that they would hold
longer term debt till maturity. With so many buy-and-hold
participants, liquidity comes almost exclusively from foreign
banks and primary dealers. However, Mehta noted that when

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interest rates are not favorable, these parties lose interest
and liquidity vanishes completely.



Indian Banks Find Direct Lending More Attractive than Buying
Corporate Debt

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8. (U) At present, Indian banks have different accounting
norms for holding loans and bonds; these norms -- and the fact
that banks earn higher interest rates from direct loans -- make
corporate bonds less attractive. Banks charge about nine
percent or more interest for loans, but they do not have to use
mark-to-market (MTM) accounting for such loans. In contrast,
banks earn only about eight percent interest for holding
corporate bonds and must record them on a MTM basis, which is
more cumbersome than accounting for direct loans. While there
is no risk differentiation between corporate loans and bonds,
Ghiya pointed out that the incentive for corporate lending in
lieu of holding corporate bonds will be lost once banks
implement Basel II norms. As a result, all corporate lending
would be treated on the same risk basis for capital adequacy
purposes, which may make corporate bonds more attractive than
they are currently for Indian banks.



Government Bond Market

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9. (U) Traditionally, banks and insurance companies have been
the largest holders of government securities (GSecs). The major
part of the holdings of these investors is generally in the
nature of statutorily-mandated investments; Indian banks are
required to maintain 24 percent of their deposits in government
securities. N.S. Venkatesh, Managing Director and CEO, IDBI
Gilts, described banks as the major captive buyers of government
bonds. In addition, insurance companies, provident and pension
funds are required to invest 20-25 percent of their assets in
GSecs. In total, the banking and insurance system holds almost
60 percent of issuances, making them unavailable for trading in
the secondary market, he claimed. Non-Banking Financial
Companies (NBFCs),another major player in the bond market, are
also required to invest 15 percent of their assets in GSecs.




10. (U) Venkatesh estimated that in 2008, about Rs. 3.06
trillion worth of government bonds, or about $65 billion, were
issued in the primary market but the trading volume in the
secondary market was about Rs. 12 trillion or $255 billion.
This indicates that the trading volume is 5 times the volume of
issuances in the primary market. However, the same trading
volume in developed countries ranges from 10 to 12 times of
annual issuances. The Indian GSec market has no retail
participation, he complained, which he blamed on low investor
awareness and low returns, compared to other avenues of
investment. Competing with G-sec, a five-year fixed deposit
through the government-sponsored small saving scheme currently
pays eight percent interest, tax free. In contrast, government
bonds pay roughly 4.5 percent taxable interest, making GSecs
unattractive to retail investors. FIIs are unlikely to provide
the secondary market trading volumes in G-secs either, because
their holding cap in this market is only $5 billion. Many
market observers noted that at such small amounts FIIs will not
invest the resources to be active traders. Ghiya further noted
that the new scheme for allocating FII holdings, just
implemented May 15, poorly suits the rush-in, rush-out arbitrage
positions FIIs prefer to take.




11. (SBU) Comment: While the Indian government, SEBI and RBI
continue to take small steps to build a robust and liquid
corporate bond market, the domestic government bond market still
dwarfs it. Market players dismiss regulators' apparent focus on

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cultivating retail participation, and many expect FIIs to
eventually jump-start trading. All agree that there is no
single switch that can turn on a robust corporate bond market,
in part because so many distortions and disincentives remain to
be disentangled. Hence, regulators and practitioners continue
to tinker and advance, hoping they eventually hit some sort of
tipping point at which market development takes on a momentum of
its own. End Comment.
FOLMSBEE