Economy Matters, August-September 2016

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In its effort to breathe new life into the Indian corporate bond market, the Reserve Bank of India (RBI) announced a slew of measures. RBI’s measures included, allowing corporate bonds to be accepted under the liquidity adjustment facility, higher ceiling on credit enhancements, providing Foreign Portfolio investors (FPIs) direct access to bond trading platforms and increasing the risk weightages for non-rated corporate borrowers. These measures are intended to further market development, enhance participation, facilitate greater market liquidity and improve communication. In the current issue of Economy Matters, the Focus of the month is on ‘Towards a Vibrant Corporate Bond Market & Developments in State Finances’. In Domestic Trends, we present analysis of the trends emanating out of the recent releases on GDP, IIP, Inflation, Trade, Balance of payment and Monsoon progress. Corporate performance in 1QFY17 has been analysed as well. In Policy Focus, we present the highlights of the key policy documents released during August-September 2016. Analysis of monetary policy stance of central banks of US, Japan and UK is covered in Global Trends.
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  • 1. ECONOMY MATTERS 2
  • 2. 1 FOREWORD SEPTEMBER 2016 T he month of September 2016 saw two major central banks, the Bank of Japan (BoJ) and the US Federal Reserve announce their policy decisions. Both of them acted on the expected lines and delivered little surprise. The Fed decided to leave interest rates unchanged, but it strongly sig- nalled it could still tighten monetary policy by the end of this year as the labor market improved further. BoJ meanwhile revealed a new monetary policy framework in order to stimulate Japanese economy and help it reach the 2 per cent inflation target. Under the new policy framework, the central bank will target interest rates on government bonds to achieve its elusive inflation target, after years of massive money printing that had failed to jolt the economy out of decades-long stagnation. The Bank believes that its monetary policy and the Government’s fiscal policy as well as initiatives for strengthen- ing Japan’s growth potential will produce synergy effects, and thereby will navigate Japan’s economy toward overcoming deflation and achieving sustainable growth. On the domestic front, although GDP growth moderated to 7.1 per cent during the first quarter of 2016-17 as against 7.5 per cent during the corresponding period last year, there are firm indications that economic conditions would improve in the coming quarters and new growth opportunities would emerge when the anticipated boost in demand takes root propelled by good monsoons, the Pay Com- mission Award and the recent reform initiatives announced by the government. The good performance of the manufacturing sector, which grew at 9.1 per cent is indeed heartening and points towards better co-ordinated policies in this area. Inflationary pressure as measured by CPI has moderated sharply on the back of fall in food prices. The latter has been precipitated by a near normal monsoon so far. Going forward, we expect CPI inflation to settle within the RBI’s target of 5 per cent for March 2017. In its effort to breathe new life into the Indian corporate bond market, the Reserve Bank of India (RBI) announced a slew of measures. RBI’s measures include, allowing corporate bonds to be accepted un- der the liquidity adjustment facility, higher ceiling on credit enhancements, providing Foreign Portfolio investors (FPIs) direct access to bond trading platforms and increasing the risk weightages for non- rated corporate borrowers. These measures are intended to further market development, enhance participation, facilitate greater market liquidity and improve communication. An active, well-oiled cor- porate bond market can help in channelising savings, both from India and abroad, through the bond route and can complement the traditional banking sector lending. Chandrajit Banerjee Director General, CII
  • 3. 3 SEPTEMBER 2016
  • 4. 5 EXECUTIVE SUMMARY SEPTEMBER 2016 Focus of the Month: Towards a Vibrant Bond Market & Developments in State Finances The Reserve Bank of India (RBI) recently announced a series of measures for the development of fixed income markets. The announcements were quite comprehen- sive and aimed to promote both market efficiency and liquidity. This came in the backdrop of the recently an- nounced report of the Working Group on development of corporate bond market in India under the Financial Stability and Development Council (FSDC) sub-com- mittee. The recommendations in the FSDC report aim to promote greater market liquidity, increased market participation and greater transparency. RBI’s measures included, allowing corporate bonds to be accepted un- der the liquidity adjustment facility, higher ceiling on credit enhancements, providing Foreign Portfolio inves- tors (FPIs) direct access to bond trading platforms and increasing the risk weightages for non-rated corporate borrowers. These measures will go a long way in en- hancing investor confidence in the Indian fixed income markets. To achieve the desired results, it is equally im- portant to ensure active participation from non-bank participants. Interlinked with the theme of a vibrant bond market is the importance of healthy condition of State Finances in India especially with the introduction of GST. In this month’s Focus of the Month, experts pro- vide their viewpoints on these two important topics. Domestic Trends GDP growth in the first quarter of the current fiscal came in at 7.1 per cent as compared to 7.5 per cent in the same quarter last year, while gross value added (GVA) at basic prices posted a growth of 7.3 per cent in 1QFY17 as compared to 7.2 per cent in 1QFY16. The sectoral data print reveals interesting insights into the data. Even as investment growth contracted in 1QFY17, government consumption expenditure growth posted double-digit growth. Private consumption growth con- tinued to post respectable growth rate. Going forward, Pay Commission payouts, contained inflation and easy monetary conditions are expected to support demand. Meanwhile, data on Index of industrial production (IIP) fell back into the negative territory, declining by 2.4 per cent in July 2016 as compared to 2.0 per cent growth in the previous month. Contraction in manufacturing and capital goods output led to the disappointing numbers during the month. On the inflation front, WPI inflation edged up in August 2016 on the back of higher prices recorded in fuel and manufacturing sectors. In contrast, CPI inflation moderated sharply, providing relief to the policymakers. Corporate Performance The corporate results at the end of the first quarter of fiscal year 2017 brought a reason for cheer in the form of rising profitability as the financial performance of In- dian companies, especially manufacturing sector firms, improved during the quarter. Manufacturing sector, buoyed by a significant fall in inputs costs following the collapse of global commodity prices, registered a sharp pickup in profitability growth in 1QFY17 as compared to the same quarter a year ago. Worryingly, both bottom- line and top-line of services sector firms has continued to remain weak so far. The analysis factors in the finan- cial performance of a balanced panel of 1749 manufac- turing companies (excluding oil and gas companies) and 815 service firms extracted from the CMIE’s Prow- ess database. Global Trends In line with expectations, US Federal Reserve main- tained status-quo and kept the Federal funds target range unchanged at 0.25-0.50 per cent in its meeting held over two days on 20-21 September 2016 as it await- ed more evidence of progress toward its goals, while projecting that an increase is still likely by year-end. As regards to its evaluation about the economic activity, the Fed upgraded its assessment of the economic activ- ity on upbeat economic data prints emanating from the economy. Back in Asia, Bank of Japan (BoJ) Governor Haruhiko Kuroda announced a new monetary policy paradigm in order to stimulate Japanese economy and help it reach the 2 per cent inflation target. The intro- duction of “yield curve control,” in which the Bank will press for the decline in real interest rates by control- ling short-term and long-term interest rates, would be placed at the core of the new policy framework.
  • 5. ECONOMY MATTERS 6 FOCUS OF THE MONTH Towards a Vibrant Corporate Bond Market side issues. However fails to fully address the demand side pressure points. The development of bond markets needs sustained participation of long-term institutional investors across the credit curve, which is a challenge the Indian bond market continues to grapple with. RBI’s measures include, allowing corporate bonds to be accepted under the liquidity adjustment facility, higher ceiling on credit enhancements, providing Foreign Port- folio investors (FPIs) direct access to bond trading plat- forms and increasing the risk weightages for non-rated corporate borrowers. RBI’s measures for the development of the fixed in- come and currency markets are a step in the right di- rection and can help broaden the market over the medium- to long-term. These initiatives along with the successful implementation of the bankruptcy laws can help broaden the markets, assuming some of the other issues relating to reissuances, stamp duty and asymme- try of information are addressed in the interim. T he Indian corporate bond market, despite nu- merous efforts by the regulator, continues to be stuck in pursuit of the ‘holy grail’. A truly vibrant and efficient corporate bond market would be char- acterised by a high degree of depth across the credit curve, greater liquidity, protection of creditor rights and low information asymmetry, among other things. The recent measures by the Reserve Bank of India (RBI) is a welcome step for the development of the bond market and rightly addresses some of the major supply The Indian Corporate Bond Market in Pursuit of the ‘Holy Grail’
  • 6. 7 FOCUS OF THE MONTH SEPTEMBER 2016 Higher rated corporates will directly benefit in the short-term due to the last mile efforts of Raghuram Rajan; however the investment guidelines for most in- vestor classes will require changes, to move down the credit curve. Banks and Financial institutions will largely remain the primary source of funding for corporates, particularly stressed corporates. India Ratings esti- mates that the number of borrowers above the thresh- old of Rs 100 billion debt obligation aggregates 50 - out of which potentially 24 are either stressed or fairly vul- nerable. The measures are likely to give a fillip to the lower rated category bonds in the long run as the banks reduce their reliance on loans as an instrument of providing credit to large corporate issuers. This will incentivise a more dis- ciplined corporate behavior and not necessarily a more diversified investor base for them. In the developed bond markets, the appetite for speculative/non-invest- ment grade bonds remains high and they are issued and traded widely. In the Indian bond market however it is not as easy to place a bond below ‘AA category’ and hence a successful and speedy implementation of the bankruptcy law is keenly anticipated by potential inves- tors with higher risk appetite. Measure to increase the aggregate partial credit en- hancement ceiling to 50 per cent from the earlier 20 per cent, subject to a single banks exposure of 20 per cent, will help corporates to raise money through bonds. As- suming these partial guarantees help improve the rat- ing of the underlying borrower, this potentially has the scope of widening the market for potential issuers. The development of dedicated institutions to provide credit enhancement and the introduction of the covered bond regulations, among others can be some of the other steps which can spur the bond market. The RBI has made an attempt to provide liquidity in the bond market by allowing brokers to be part of corpo- rate bond repo facility. In most developed bond mar- kets, corporate bonds are permitted to be used as collateral for liquidity operations. Allowing corporate bonds as collateral for liquidity operations will improve the demand for corporate bonds, from the perspective of banks subscribing to these bonds. This will help de- velop a robust secondary market for ‘AAA rated’ bonds (assuming the final guidelines restrict it to AAA paper). However, this is unlikely to result in investors moving down the credit curve due to uncertainties relating to recoveries and asymmetry in information sharing. In a scenario, where AAA papers remain in short supply due to bank investments, it could help in the gradual pro- cess of migrating down the rating curve. Current measures have not addressed issues with re- spect to information asymmetry. A bond holder typi- cally gets information with a lag (especially where the underlying performance is deteriorating) limiting the ability of the investors to go down the credit curve and price the product attractively. Disclosure of covenants and compliance could be made mandatory to improve information asymmetry. The recent SEBI circular relat- ing to information disclosure (including ratios like DSCR among others) is a positive step and it could be further strengthened with disclosures on covenants and com- pliance. This is an international practice that both equity and debt investors can benefit from. Long term investors namely pension, provident, gratui- ty funds’ among others are major investors in the Indian bond markets and look for long term investment oppor- tunities. The investment policies of these funds need to be aligned with the regulatory changes. The last time changes were made to the investment policies of these funds it resulted in some debt market issuers migrating to the bank loan market. Unless investment policies of these funds are aligned with other regulatory changes, it will be difficult to develop a deep and vibrant corpo- rate bond market in India. Giving direct access to FPI in the trading platform will add more vigor, especially in the shorter end of the curve. However, it will also mean faster transmission of shocks. Moreover, wide divergences in the normal ticket sizes for FPIs and retail investors compared to the normal market lot of Rs 50 million and the price impact may together deter large scale participation in the near term. Listed corporates can now park short term surplus cash under the repo facility with banks and primary dealers. Corporates holding on to high short term cash balances or parking funds with banks may turn to this window; however with better returns from liquid funds this
  • 7. ECONOMY MATTERS 8 FOCUS OF THE MONTH mode is unlikely to witness a shift in volumes from MFs to banks. India as a country provides a superior rating distribution, as compared to other emerging markets because of the RBI’s steps to encourage ratings on bank facilities. Fur- ther, realignment of the risk weightages between low rated and unrated corporate borrowers, would improve the quality of information. RBI’s measures address a lot of the supply side issues facing the corporate bond market. Demand side meas- ures, however are in the domain of multiple regulators and each regulator comes with their own set of regu- lation/investment guidelines. The speed and scale of developments and innovation in the financial markets poses a challenge for constantly improving the regula- tors capacity. Each regulator namely Securities and Ex- change Board of India (SEBI) Pension Fund Regulatory and Development Authority (PFRDA), Insurance Regu- latory and Development Authority of India (IRDA), RBI though right in their own way but often do not have a consensus on the larger goal of development of the cor- porate bond market. Long term measures to develop investor interest with varying risk appetite would also hinge on increasing the role of alternate investors to banks, who apportion a large dominant part of financial savings in the economy. Over specifying of regulations creates artificial barriers, thereby leads to distortion and inefficient markets. For example, the credit enhancement scheme which speci- fies the amount per bond issue per bank or the rating grade restrictions for investments by insurance com- panies. Regulations targeted at tackling the risk arising out of such provisions without limiting the ability of markets to innovate would be required. Support from various stakeholders can lead to a vibrant corporate bond market in India, which otherwise continues to be dominated by the public sector and financial institu- tions. Globally, the amount of sovereign debt with negative yields has touched US$13 trillion. This provides a good opportunity for all the stakeholders to kick start the corporate bond market in India. Steps to develop masa- la bonds could also help corporate issuers to develop an overseas rupee bond market. (Views expressed are personal)
  • 8. 9 FOCUS OF THE MONTH SEPTEMBER 2016 Developing the Corporate Bond Market T he regulatory initiatives for development of cor- porate bonds so far have been primarily focused on product innovation (credit default swaps, cor- porate bond repo) and infrastructure aspect (manda- tory trade reporting, exchange based settlement, elec- tronic bidding platform for private placements). While product development and robust market infrastructure are critical enablers, it is equally necessary to have a di- versified pool of issuers, intermediaries and investors in order to provide adequate depth and breadth to the market. A well-functioning corporate bond market can not only provide the much needed alternative to tradi- tional bank financing, but can also help reduce borrow- ing costs for corporates through market based pricing of credit risk. The Reserve Bank of India (RBI) has recently announced a series of measures for the development of fixed in- come markets. The announcements are quite compre- hensive and aim to promote both market efficiency and liquidity. This comes in the backdrop of the recently an- nounced report of the Working Group on development of corporate bond market in India under the Financial Stability and Development Council (FSDC) sub-commit- tee. The recommendations in the FSDC report aims to promote greater market liquidity, increased market par- ticipation and greater transparency. Firstly, the RBI has issued a discussion paper with a view to mitigate credit concentration risks in the banking sys- tem. According to the proposed framework, large cor- porates would need to rely on debt capital markets for their incremental funding requirements. This measure will give a major boost to the bond market and will lead to greater diversity of issuers in the corporate bond market. However, the investor appetite for issuers across the credit curve would be a key determinant in achieving the desired objective. Investment guidelines of insurance companies and domestic retirement funds may need to be amended for facilitating investment in these bonds. In order to make bond markets accessible to lower rated issuers, the aggregate limits for partial credit en- hancement provided by banks to corporate bonds have now been enhanced to 50 per cent of the issue size in- stead of 20 per cent earlier. This should enable greater infrastructure financing through bond markets, as the credit enhanced bonds can appeal to a wider category of bond market investors. In a very significant development, the Parliament has recently passed the Insolvency and Bankruptcy Code, 2016. The key benefits include time-bound resolution of corporate defaults (much on the lines of Chapter 11 fil- ing in the US) and providing a forum to capital market participants for resolution of disputes relating to corpo- rate bankruptcies. This is a very positive development, and once implemented, investors are expected to view lower rated companies more favorably. However, the success of the Bankruptcy Code would depend upon the implementation of the associated legal infrastruc- ture to support the new framework. The progress on this front will be crucial to the bond market and will be
  • 9. ECONOMY MATTERS 10 FOCUS OF THE MONTH watched closely. RBI has permitted Indian corporates to issue Rupee de- nominated bonds overseas. This is a win-win product for both issuers and investors. While issuers can access new pools of investor capital without assuming curren- cy risk, investors can access Rupee exposure in an op- erationally convenient manner. Recently, RBI permitted Indian banks to issue Rupee bonds overseas, both for raising capital and infrastructure lending purpose. Since Indian banks are familiar names in the USD bond space, there would be investor demand for these bonds. This would also help develop the offshore quasi-sovereign Rupee yield curve and will facilitate better price discov- ery for Rupee denominated bond issuances for corpo- rates going forward. In order to promote the repo
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