Financialisation and bond markets

Why bond markets? Issue not whether bond markets are good or not, but whether they can emerge and grow and if so how and with what implications. If a market for long term bonds exists, along with a liquid secondary market to trade them, this provides an alternative way of financing long term investment without much mismatch of liquidity and maturity. The argument is that since governments (unwilling to tax) are strapped for funds and there are limits on bank funding, this is an imperative. Essential for infrastructure financing. Since in principle bonds can be securitized, the risks associated with financing long term investment can be pooled and shared.

Problem for finance capital Bond market development in developing countries is inadequate and skewed. In most countries corporate bond markets don’t exist, and where they do not all firms cannot enter them. Only highly rated bonds work and that too through the private placement route. Bond financing for infrastructure is particularly underdeveloped.

Bond markets in developing countries Not a process of evolutionary emergence along with development and associated financial complexity. Attempt to generate them through accommodative or proactive state policy. Two stages: first, “marketisation” of government securities; and, second, create a market for financial and non-financial private or corporate bonds.

Govt bond market formation The search for additional investment targets for finance capital Not possible if government borrows from the central bank or banks subject to mandatory requirement. Fiscal reforms forecloses that. “Market borrowing” through mechanisms such as auctions encouraged in the name of price discovery Leads to volatile rates and prices. Serves the need for a benchmark rate, in this case a low risk instrument. That along with other fiscal objectives associated with neoliberalism could limit the size of this market.

Closing the gap for long term finance Achieved in developing countries with tax-financed spending, managed government borrowing and specialized financing supported by the central bank and the state. The government’s failure to mobilise adequate resources through taxation and its post-reform emphasis on fiscal consolidation, which limits its borrowing, has reduced its capital spending. This requires the private sector to play a greater role in capital intensive industries and infrastructure. Relying on commercial bank funding for the purpose results in liquidity and maturity mismatches that become difficult to manage. Need felt for a corporate bond market. But takers only in a few countries.

Weak corporate bond markets Small size and slow growth. Even of these much mobilized through the private placement route rather than through public issues. Only highly rated companies can mobilise such funds, with little spread in ratings in the market. Difficult to get funding for infrastructure projects with lumpy investments and long gestation lags. Company specific rather than project specific bond issues.

Layering Growth very often through layering. Non-bank finance companies issue bonds, which most often are bought up by banks and financial investors. Bonds tend to be of shorter maturity than the investments they help finance. Roll-over of debt crucial. Any deterioration of the environment or individual failure triggers a liquidity squeeze, that can result in multiple failures.

South Africa: Govt dominance

Turkey old style

China: Borrowing to sustain growth

Typical measures to drive a corporate bond market Make it easier to acquire corporate bonds and government securities Allow foreign portfolio investors to trade directly in corporate bonds without involving brokers Increase the liquidity associated with corporate bonds by making those bonds eligible to be considered as collateral, including in central banks liquidity management operations allowing brokers to participate in the corporate bond repo market. Create new hedging instruments that allow domestic players to issue foreign currency bonds and hedge against currency risk.

Typical measures to drive a corporate bond market 2 Adopt measures that encourage banks to issue new bonds. These include allowing banks to issue local currency denominated bonds in foreign markets in the form of higher yielding Perpetual Debt and other debt instruments that can qualify as either Tier 1 or Tier 2 capital when computing capital adequacy. Allow banks to issue of such bonds to mobilise capital for infrastructure financing.

Typical measures to drive a corporate bond market 3 Banks are roped in to render bonds less risky by launching partial credit enhancement (PCE) schemes. Under them banks are allowed to provide partial credit enhancement to bonds issued by corporate entities and special purpose vehicles. This involves providing a non-funded but irrevocable line of credit linked to a bond issue, which companies can access to meet commitments in case they find themselves unable to meet interest or amortisation payments on the bonds. Even a 20 per cent enhancement scheme could elevate a BBB rated bond to the A or AA category.

Engineered growth It is important to note that while these measures are being presented as part of a market-friendly reform process, the bond market here is not expected to evolve autonomously to mitigate information and transaction costs as that approach suggests it should. Rather the government is seeking to engineer the emergence and expansion of a market it sees as required to support long term investments. If the bond market does emerge an important source of long term capital in India, it would be because of intervention and not deregulation.