IN any mature economy there are four major sources that ensure adequate funding of industrial, infrastructure and corporate requirements: banks, equity, government securities and corporate bonds.

In India, the first three components have developed reasonably well in recent years and provide necessary funding for both the private and public sectors. Unfortunately, the corporate bond market has lagged behind for a variety of reasons.

But as India’s economy expands at a breathtaking nine-plus per cent per annum, the appetite for funds to fuel this gigantic beast keeps growing. For India’s economy to grow at a much faster clip – of between 10 and 12 per cent annually (needed to reduce poverty and raise the standard of living of millions of poor people) – the country has to invest nearly $500 billion in building new infrastructure and upgrading existing ones over the next five years.

The three existing sources of finance are proving to be highly inadequate to fund these huge requirements. Even international sources – foreign direct investment (FDI) – will be unable to help bridge this funding gap. For that, the country has to ensure rapid development of the corporate bond market.

According to a recent report by Goldman Sachs – Bonding the BRICs: A big chance for India’s debt capital market’ – (BRICs was a coin termed by the US-based financial giant, relating to the four emerging economic giants, Brazil, Russia, India, China), the government will have to deepen financial sector reforms to expand the debt market in the country.

The investment bank reckons that India’s corporate bond market represents a mere two per cent of GDP, as against 25 to 30 per cent in developed countries like the US and the UK. The Indian bond market is dominated by instruments issued by governments, state-owned companies and banks and insurance companies. Goldman Sachs estimates that India’s total debt market (both private and government) could balloon four-fold, from about $400 billion last year (which was 45 per cent of GDP) to over $1.5 trillion (about 55 per cent of GDP) by 2016.

Bonds issued by the non-government sector, including corporate bonds, could expand six-fold, to $600 billion in about eight years. In comparison, equity market capitalisation in India adds up to 100 per cent of the GDP.

The US investment bank feels that failure to reform the corporate bond market could seriously impact India’s GDP growth prospects. According to Tushar Poddar, vice-president, Asia, Goldman Sachs, the virtual absence of a corporate debt market “adversely affects two issues that will help underpin the country’s future economic growth—borrowers’ access to long-term funds and lenders’ ability to distribute risks across the economy and across time.”

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FOR the corporate bond market to turn buoyant, India needs to go in for regulatory and legislative changes. An expert committee, headed by R.H. Patil, former chief of the National Stock Exchange (NSE), had about two years ago urged the government to rationalise stamp duties on corporate bonds and also abolish tax deduction at source. Y.V. Reddy, the governor of the Reserve Bank of India (RBI), the country’s central bank, recently said that it plans to allow market repos in corporate bonds, letting bond-holders to borrow against the securities. This move should boost turnover in the bonds market.

However, Reddy added a rider, pointing out this would happen only after an efficient price discovery mechanism is in place, following a significant rise in public issues and secondary market trading. A system of net settlement of funds and securities should also be in place, he says.

The central bank governor assured American investors that India would open its debt market to foreign investors once an efficient and safe settlement system is in place. “In the medium term, considering the overall macro-economic situation, the ceiling for foreign investment in both government securities and corporate debt will continue to be calibrated as an instrument of capital account management,” said Reddy.

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Foreign institutional investors (FIIs), who have ploughed in over $19 billion into the capital markets in 2007, are allowed limited exposure in the corporate bonds market. At present, RBI limits the investment in corporate bonds to $1.5 billion, and in government securities to a little over double that figure.

The RBI chief also wants the government debt to GDP ratio to be brought down from the current high level of 80 per cent to just around 50 per cent. “A more liberalised access to foreign investment would be appropriate when, among other things, an efficient and safe settlement system is well entrenched, aggregate consolidated public debt to GDP ratio reaches a reasonable level, say less than 50 per cent, and the corporate debt market acquires depth and liquidity with significant role for insurance and pension funds in India,” says Reddy.

At present, corporate debt accounts for less than 15 per cent of the total debt market, and the average daily trading volume in the corporate bond market is a meagre Rs3.5 billion. Both the premier stock exchanges in the country – the Bombay Stock Exchange and the NSE – have launched reporting platforms for corporate bonds, and trading volumes have been rising, and are likely to cross Rs800 billion in 2007.

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THE Securities and Exchange Board of India (SEBI), the capital market regulator, last week initiated some reforms that could make the corporate bond market more exciting. For the first time, issuers can now come out with ‘junk bonds,’ paying higher interest to those inclined towards higher risk. At present, debt instruments launched through a public or rights issue have to be of at least investment grade. “In a disclosure-based regime, it should be left to the investor to decide whether or not to invest in a non-investment grade debt instrument,” the regulator said while announcing the move. “Given this, and in order to develop a market for debt instruments, it has been decided to allow issuance of bonds which are below investment grade to the public to suit the risk/return appetite of investors.”

Companies that have a patchy credit track-record can now approach the market directly, offering better interest rates to investors with a higher risk appetite by issuing junk bonds, which carry a credit rating of BB and lower. SEBI hopes the move would revive the corporate bonds market in India.

Junk bonds have been popular in the US for several years. Interestingly, the past few months – after the sub-prime mortgage crisis in America – there has been a virtual drying up of the junk bond market, both in the US and Europe.

In fact, junk bond returns in the US this year are down to 0.7 per cent, the lowest in five years. Investors have been pulling out money from the junk bond market, fearing a backlash from sub-prime mortgage defaults. In another move to push the sector, SEBI also allowed companies to issue bonds after getting ratings from just one credit-rating agency, instead of the two earlier.

According to the regulator, this has been done to reduce the cost of issuing debt instruments. Structural restrictions on debt instruments, like maturity and put-call option on conversion, have also been removed by SEBI. This would enable issuers to tailor instruments according to their requirements and make the entire process flexible. However, a lot more needs to be done to breathe life into the corporate bond market, including abolishing tax deduction at source and rationlising stamp duties. The bond market is currently dominated by banks, mutual funds and primary dealers, while provident and pension funds are not allowed to dabble in corporate bonds.

The R.H. Patil committee had also suggested the setting up of an online order-matching platform for trading in corporate bonds. The government also plans to set up a single exchange-traded market for these bonds in the future to ensure healthy growth of this vital segment.