It would be difficult to fault the objectives that underlie the guidelines on credit default swaps announced by the Reserve Bank of India on May 23, 2011?increasing investor interest in Indian corporate bonds and developing the Indian corporate bonds market. Combine this with the obvious advantages that credit default swaps offer?reduction in the overall cost of borrowing and access to bond markets for a wider range of issuers?and you have just the right initiative that the markets needed. But would the product in its present form take off? Let us take a closer look.
The backdrop first: Indian corporate bond markets are underdeveloped. They lack secondary market liquidity and have a near absence of credit derivatives. Consequently, primary issuances are relatively low (annual issuances being around $40 billion) and outstanding corporate bonds aggregate a mere 9% of GDP. Compare this to the developed world: Corporate bonds outstanding were 70% of GDP for the US, 147% for Germany and 21% for Japan. At 11% of GDP, even China had a march on us.
The case for bigger and deeper Indian bond markets is based as much on reducing the present over-reliance on banks for providing medium and long tenor loans, as for creating a diversified financial system that achieves efficient capital allocation. A case in point is the present demand for debt to fund the country?s infrastructure spend, wherein the domestic banks cannot cope, rupee denominated foreign debt investment can come in only through the medium of corporate bonds, and such investment demands a liquid bonds market.
So how does the introduction of this product provide an answer to the needs for funding infrastructure and broadening the bond markets? For one, it allows banks to avoid mismatches in their ALMs associated with long-term loans (tenors of over 10 to 15 years) by merely doing what they know best?undertaking credit risk. They take on the role of credit default swaps? sellers at a premium or spread over the life of the swap. The funding is provided by international funds (FIIs) who are in a position to take on long-term exposures, albeit on a counterparty like an Indian bank or a financial intermediary whose risk they understand. So global capital, whose cost is at an all time low, finally has a structure through which it can be ploughed into the Indian debt market.
This structure applies equally to investment by Indian provident funds and insurance companies who currently buy over 70% of fresh bond issuances every year but have hitherto lacked the ability to invest in SPV structures of infrastructure projects that are low on ratings.
The second advantage that the introduction of credit default swaps will bring is to provide enhancement to ?A? and lesser rated issuances. Note that 91% of all corporate bond issuances in India are the highly rated ?AAAs? and ?AAs?, which limits issuers to only marquee names. All lesser rated borrowers avail credit, but almost entirely from the banking system. How very different this is from a developed bonds market like the US where only 2% corporate bond issuances were ?AAA?, 14% ?AA?, close to 47% issuances were in the ?A? and ?BBB? categories, and 20% comprised the junk bond category. With the introduction of the credit default swaps, we have a real opportunity of broadening the market and bringing the ?A? and lesser issuances to the institutional investors, particularly to the mutual funds that have otherwise shied from this category.
This, then, is the obvious case for the credit default swaps. But the market will only evolve quickly if three things fall in place. First, the FIIs hone in on opportunities in structured debt for ?infrastructure? issuances suitably advised by domestic originators, and enough long-term money is garnered abroad by India-specific funds. Secondly, FII debt investment limits are enhanced beyond their current ceilings (which are exhausted) for corporate debt of all issuers (and not just infrastructure) so as to give a fillip to the high yield (?A? and below) issuances. Finally, Indian banks (including branches of foreign banks) are able to obtain a return on capital that is close to their normal lending activity, because exposure norms and charge on capital would be the same. This is why the early growth for the product needs to come from selling credit default swaps to FIIs that have a lower cost of capital and could settle for lower returns (after accounting for credit default swaps? spread cost) than domestic investors. Also, FIIs, unlike most of the other domestic ?users?, are expected to be relatively unfamiliar in dealing with Indian corporate credit risk or with the resolution of credit defaults, and so are the most likely early users.
In allowing FIIs to hedge exposures on Indian corporate bonds through credit default swaps and in making an exception where credit default swaps can be issued even against unrated and unlisted infrastructure bond issuances, the guidelines offer the most market-friendly solution to the vexed problem of infrastructure financing. But then, the guidelines limit the selling of credit default swaps or the buying of protection without holding the underlying bond only to entities directly controlled by the central bank viz commercial banks, stand alone primary dealers and NBFCs. And even here, there are stringent norms on financial strength and risk management abilities before applicants qualify. Couple these with the applicability of exposure and capital charge norms to all outstanding credit default swaps in the books of such entities, the marking-to-market, plus the disclosure norms for all transactions and outstanding positions, and the case for preventing systemic risk could not have been made with greater rigour.
So could this rigour stifle the market? Limited participation in ?market-making?, and with most players not allowed to purchase a credit default swap unless they hold the underlying instrument, certainly deprives the market of volumes and thereby efficient pricing. But these are early days and if participants do take to this product, it is expected that the Reserve Bank of India would eventually relax participation and that would raise the market to the next level.
The author is managing director & CEO, Almondz Global Securities Ltd