India is crying out for corporate bonds. The country's bank-dominated financial system is not well-suited to fund the $1 trillion infrastructure investment targeted by the government under its current five-year plan. Corporate bonds could be a helpful alternative, but the authorities are stifling the development of a genuine debt market.
Banks make money by transforming short-term deposits into longer-term loans and managing the risks inherent in the process. Indian lenders are no exception; they tend to accumulate longer-term assets at a somewhat faster pace than liabilities of the same maturity. About half of infrastructure loans are long term in nature, according to the central bank's research. If the asset-liability gap becomes too large, the banking system becomes vulnerable to a confidence crisis.
Bank loans account for about 32 percent of the non-equity, external financing for India's companies; the bond market provides just 7 percent of the funds, according to a recent working paper by the New Delhi-based National Institute of Public Finance and Policy. The bond market's share of corporate finance has been virtually unchanged in the past 10 years.
After many years of debate, there is now at least a hint of progress. The Reserve Bank of India recently allowed sell-and-repurchase, or repo, transactions in short-term corporate paper. This will hopefully breathe life into a repo market that has refused to take off. The list of securities eligible for credit default swaps, a form of insurance protection for bondholders, is also being expanded. Some of the building blocks are finally falling in place. But even now, the bond market is not getting the emphasis it deserves. Part of the reason is the state's apprehension about what a successful corporate bond market would do to its own borrowing costs.
The dominance of banks is a big advantage for the government, because the authorities require banks to park 23 percent of their customers' deposits in government bonds. By helping itself to a large share of lenders' deposits, New Delhi keeps its own funding costs down. If the finance ministry and its fund-raiser - the central bank - were to compete for those funds in a free market, the interest rate on public debt would be a lot higher.
As things stand, the real, or inflation-adjusted, rate is negative: Subtract 10 percent consumer-price inflation from nominal yield of about 8 percent, and the real rate on 10-year bonds is minus 2 percent. Since households are the ultimate