Debt market to raise credit

India Today, 15 October 1994

The National Stock Exchange (NSE), India's first debt market, opened for trading two months ago. This is a market where debt instruments, such as government securities and corporate debentures, are traded the same way that the traditional stock exchanges of the country trade shares. Before the market is pronounced fully operational, it should display high transaction volumes and consistent trading in important instruments day after day.

So far, trading volumes have averaged only around Rs 750 crore a month and many instruments are not transacted on any given day. At this point, it is useful to ask: How does it matter to have the debt market fully functional? We will take a look at the five most important issues here.

Giving the economy a set of interest rates: Let us first restrict our attention to government debt, where the risk of default is essentially zero. The activity of trading on the NSE serves to constantly provide the economy with market-determined interest rates for various time horizons. This is in contrast with the minimum lending rate set by the RBI, which is revised infrequently, and does not dynamically reflect the unfolding events of the economy, and how they reflect upon future expectations, upon supply and demand conditions.

To appreciate how much of a difference this makes, imagine a world where some government agency sets the price of shares in ACC, and modifies this price a few times a year. Even if this agency made no attempt to use this price-setting power as an instrument of policy, it would at best be slow in modifying this price in response to events. Now imagine that we move from this situation to one where ACC is traded on the stock market. The market-determined price reflects information on ACC and the cement industry every day.

Because a wide spectrum of government securities exists, the NSE would actually end up supplying us with a yield curve, or the interest rates charged for reckless loans of different durations. Anytime someone in the economy wishes to price a riskless payment occurring in the future, he could use the yield curve from the NSE to find out the interest rate. The importance of the minimum lending rate would thus be substantially reduced.

The default spread: What happens if a company wants to issue a debt instrument which pays in 364 days, when direct competition in the form of a 364-day government treasury bill exists? Because any company is susceptible to a little more default risk than the Government, the market-determined interest rate which the borrower is compelled to pay will be higher than that paid by the Government. This difference is called the default spread. The debt market will constantly gauge the credit risk of debentures issued by various entities and determine the default spread for each of them. It would do this more efficiently and respond to information faster than conventional banks and credit rating agencies. When bad news for a company appears, the secondary market price of debentures issued by that company will instantly drop; that is the required yield or interest rate will go up.

Reducing the cost of debt: Before the debt market is fully functional, debt instruments show poor liquidity. The investor suffers from poor liquidity, and hence issuers are forced to pay higher prices, called the liquidity premium. This premium takes the form of high interest rates or an attractive conversion clause. Once debt instruments acquire liquidity, there will no longer be a need to pay this liquidity premium. The cost of debt for all corporations will drop as a consequence.

Enable infrastructure investment: The age when government took responsibility for funding all large infrastructure projects is clearly over. A variety of public and private sector agencies are likely to be involved in infrastructure projects in the coming years, and the scale of resources required for these projects is likely to be enormous. It is difficult to finance such projects, with their long gestation periods and slow payback, by issuing equity on the primary market. It makes far more sense to create debt-intensive financing packages for infrastructure projects. The debt market will be vital in enabling this.

Capital inflows: Just as we have seen capital inflows into the stock markets of the country, we can expect to see large capital inflows into the debt market. These will tend to eliminate the interest rate differential between India and abroad. These lower interest rates will enhance investment in India and ease the servicing of the enormous debt of the Government.

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