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Much is being made of Essar Steel's travails in arranging payment on its floating-rate notes falling due later this month. Understandably, the company management and investors in those floating-rate notes are worried. But while they have cause for concern, the issue seems to have been blown out of all proportion. Corporate defaults occur as a matter of course, and will continue to happen because uncertainty is at the core of any business.
We need, however, to lay down certain general principles about corporate default. It is simply not true, for instance, that if a company defaults on its FRNs, that will affect, in some mysterious way, the country's sovereign rating. There are no state guarantees on FRNs, nor do they carry the guarantees of any state-owned financial institution. As a matter of fact, FRNs are usually unsecured, and hence no part of the company's assets are charged to the holders of these instruments. To be sure, a corporate default may rub off on all offerings from India in general for sometime, but soon foreign investors will distinguish between the good and the bad.
More importantly, a bailout by financial institutions will actually be a bailout of foreign investors. This is absurd-all investors, including foreign ones, know that their investments are exposed to commercial risks.
These risks are usually compensated by the higher yield which they get. In fact, bailing them out raises the risk of moral hazard. Usually, when investors know that they have made a bad bargain, they will start negotiating with the issuers to arrive at some compromise settlement, such as a rollover. The point is that public money must not be used to help private creditors. That should be a general principle while deciding FIs' stand in such matters in future.
Copyright © 1999 Indian Express Newspapers (Bombay) Ltd.
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