Indian investors have been badly battered by the recent turmoil in financial markets. Short-term RBI measures aside, there is a larger need for a fundamental and long-term reform in another segment of the Indian financial market?the market for corporate debt, where investors can buy and sell debt securities issued by firms in a liquid and transparent market setting.
A big anomaly with the Indian financial market is that while it has a relatively well developed stock market, it lacks a well functioning market for corporate debt open to a large class of investors. In fact, from the beginning of this decade, share of debt in total resource mobilisation for the corporate sector has declined from 95.80% in 2000-01 to 71% in 2006-07. The debt market is still overwhelmingly dominated by the government securities. Most of these debts are held by banks and other FIs and not by ordinary investors. The proportion of bank loans to GDP was approximately 39% in 2005-06 and publicly traded debt constitutes a negligible fraction of the total market. The private placement of debt, which accounts for almost of 92% of transactions in value, indicates thinness of the market where issuers are firms with very high credit ratings and buyers form a syndicate of banks and FIs. Consequently, the secondary market for debt is almost nonexistent and illiquid where retail trade falls below 1% of total transactions. Most of these trades are also carried out in the OTC market and not in exchanges.
However, initiating a series of reforms to make this market investor and issuer friendly is easier said than done. While investing in debt securities, a potential investor has three main concerns. First, the purchase price of a bond ought to be commensurate with its quality. Second, transactions in the secondary market must not involve huge search costs of locating a partner and finally, recovery of investment must be made in a shorter time in bankruptcy.
Thus the process of reform to vitalise debt markets is complicated because problems relating to dissemination of information, design of market microstructure and resolution of legal disputes in bankruptcy must be addressed simultaneously. Bond rating agencies can curb the general informational asymmetry but trading rules must ensure timely flow of pre and post trade information which basically outlines trading opportunities before and information after a particular trade and posting information about price, order flows, volume, etc. without delays. Countries like Korea and Malaysia have required traders to report such information within 10-15 minutes of completion of a transaction and transparencies of this kind trimmed bid-ask spread to 2-5 basis points and has made the market more liquid. While implementing transparencies in trades and disseminating information via technology is relatively easier in India, the harder part of the task is to reform the legal process of bankruptcy.
So far, India?s record in this area is far from satisfactory. The latest World Bank index of ?closing a business? states that time to resolve bankruptcies in India takes almost 10 years with 9% cost of estate values and the recovery rate is 12.8 cents a dollar. Hence, mandatory disclosures of information on the part of issuers, efficient distribution of pre and post trade information to all traders via electronic medium together with a large scale reform in bankruptcy procedures are needed to make this market active. Such coordinated efforts will lead to price discovery of heterogeneous assets (with different maturity, seniority, security), infusion of liquidity, and recovery of values in bad times and will attract attention of investors. Earlier attempts to rejuvenate this market had failed because of the absence of a broad approach to deal simultaneously with aspects of liquidity, transparency, information disclosures and bankruptcy reforms.
A large number of studies show that debt and equity market are complementary and together they help adding financial depth and contribute to economic growth. In addition, development of this market will also help investors to diversify and will fill up the gap between markets with extreme risk profiles.
?The author is reader in finance at the University of Essex