Raghuram Rajan Committee Proposal 2 Analysis-Indian School of Business

INFS Group Presentation

Presenting in ‘FAVOR OF’ –

Steadily open up investment in the rupee corporate and government bond markets to foreign investors

INDIAN FINANCIAL SYSTEM – Group Presentation Class of 2013 2

Background

The Need

A view to outlining a comprehensive agenda for the evolution of the financial sector indicating especially the priorities and sequencing decisions which the government must keep in mind

The Enabler - Rajan Committee

High Level Committee on Financial Sector Reforms Mr. Raghuram Rajan and some of the respected names in the industry Formed in 2007

The Result

The Committee Report – “A Hundred Small Steps” 35 recommendations addressing the need

Our Analysis

In favor of Proposal 2“Steadily open up investment in the rupee corporate and government bond markets to foreign investors after a clear monetary policy framework is in place”


Bond Markets – Why do we need them?

Overall growth of economy driven by two important pillars of financial sector

Equity Markets Bonds

Need for efficient bond market from view of different stake holders

Overall Economyo Expands range of opportunities to finance large scale projects at centre, state and

corporate levelo Infrastructure projects are backbone for economic growth in emerging economies.

Bond markets reduce financial strain on banking system

The Corporate Borrowero Bond markets provide cost efficient source to medium and long term capitalo Extends financial inclusion to SMEso An easier way to access loans for less credit-worthy borrowers

Investors – Institutional and Retailo Facilitates investors to price borrowings and lending more competitivelyo Expands the array of financial assets that are available to institutional investorso Market determined investments reduce mismatches and facilitate portfolio management


Corporate Bond Market – Current Scenario

In its infancy stage in terms of the structure Presence barely perceptible compared to countries like US, Japan or China India has an over-reliance on loans from FI/Banks

Corporate bond market are dominated by “non-banking finance companies” and a small portion of funds raised by service or manufacturing industries


Corporate Bond Market – Barriers to Growth

Attitude of various participants in the bond marketo Corporates prefer cash credit system of bankso FII’s present in a limited way due to the ceilings on their investmentso Households absent due to lack of an efficient legal system

Evolution of the fixed income marketso Progress difficult if arbitrage opportunity between bonds and loans exists

Structure of marketso Issuing and selling bonds costlier and difficulto Ensuring liquidity and exit is a bigger headache

Over-arching prescription for instruments that are rated AA and aboveo Demand exists only for these instruments and thus the market is shrinking


Corporate Bond Market – Measures

Improve liquidity

Enhance transparency

Create safe and sound market infrastructure

Enable appropriate institutional structures like robust bankruptcy framework

Review the investment guidelines of institutional investors

Existing guidelines do not encourage large investments in bonds


Government Bond Market

Salient Features of Government Bonds

Issued at face value No default risk as the securities carry sovereign guarantee. Ample liquidity as the investor can sell the security in the secondary market Interest payment on a half yearly basis on face value No tax deducted at source Rate of interest and tenor of the security is fixed at the time of issuance Redeemed at face value on maturity Maturity ranges from of 2-30 years

Role of Government Bonds in Financial Markets

Integrates various segments of the financial market Offering virtually credit risk-free highly liquid financial instruments Willingness of market participants to transact in government securities imparts liquidity Used by dealers as a major hedging tool for interest rate risk and as underlying assets Large borrowings by the Government also provide an impetus to the development Allows greater application of indirect or market-based instruments of monetary policy


Government Bond Market – Current Scenario

Indian government bond market has grown exponentially during the last decade

Growth fueled majorly through structural changes made by government and RBI

Changes lead to enhanced transparency in market dealing & auctions

Introduction of new participants like primary dealers helped to deepen the market

Imbalance of the debt market in India

Overpowering dominance of the government bond market


Government Bond Market – Current Scenario

Government bond market grew at par with Asian countries

Issue of lack of liquidity of government bond marketso Liquidity visible in the low level of traded bondso Liquidity is concentrated in a few bonds like 10 year issues and 5 year issues


Government Bond Market – Key Issues

Market still illiquido Less than 20% of securities traded on a day in the liquid segment

Bonds in the government market are traded heavily on their introductiono Attributed to the process of price searching and duration matching

After the introduction bonds are rarely traded till their maturityo Due to inability of market to formulate accurate expectations about interest rates

o Government bond markets continue to lack in widtho On any day only 20 government securities are traded in the secondary marketo If we look at two-way quotes, they are available for only 25 securitieso The number of trades per security is low on averageo Domination by only handful of major playerso Mismatch of asset-liability of participating institutions

Challenges


FII in Indian Bond Market

Share of FII’s in government securities in India is a miniscule 0.9%

o Dominance of domestic investorso Very limited foreign participation which is largely due to policy structure of Indian debto Investment limits for FIIs have been revised

Increased to US$25 billion in government bonds US$ 50 billion in corporate bonds


FII in Indian Bond Market

Measures to boost FII’s

o RBI has been asked to open a US $10 billion window to allow foreign individuals o Will encourage flow of money as foreign investors will` be eager to invest in Indian

marketso Possibility of earning higher returns on Indian debt as compared to US/ Europeo Will result in strengthening of the underdeveloped bond market in India

o Due to absence of foreign investors, markets are deprived of a large and liquid pool of savings

o India is also being deprived of an active global trading strategy which can contribute to the liquidity woes

Problems due to low FII in Indian Bond Market


Impediments to Foreign Investment in Debt Market

FEMA Act and Its Implications

o FEMA Act basically provides guidelines for the regulation of foreign exchange in India.o One of the primary limitations of the FEMA act is that it permits only authorized person

to deal in foreign security i.e. NRIs and SEBI registered FIIs only.o The FEMA Act also sets up upper ceiling on the volumes of investments in Govt. and

Corporate Bonds along with some additional restrictions.

Measures taken by Finance Ministry to bring in reforms

o In recent times the Finance Ministry has been increasing the upper ceiling on the FIIs in the Govt. and Corporate Bonds.

o These reforms not only aim to increase FIIs in India but is also targeted to address the Current account deficit in India which is running out of control.

o Another key incentive to open up FIIs is the keenness shown by the Foreign pension funds, sovereign funds etc. to invest in Indian debt market since India debt markets give returns to the tune of 8% vs. returns of 3% to 5% in other emerging countries.


The Raghuram Rajan Committee Proposal Analysis

The Proposal

o Steadily open up investment in the rupee corporate and government bond markets to foreign investors after a clear monetary policy framework is in place

o Emphasis on clear monetary policy framework as a precursor

What would foreign investors be interested



o Favorable tax regime for international investorso A fully functional secondary marketo Transparency and Accountability of Policy Makerso Blend of Rules based plus Incentive based approacheso Ability to borrow in Local Currencyo Ability to hedge forex risko Consistency in Govt. Policyo Efficient management of fiscal deficit and CADo Stable Inflationo Industry Friendly Labor Lawso Smooth Bond Settlement infrastructure

What FII/QFIs really want from Govt.?



Competition in FDI Markets

o Competition among Asian Countries for foreign capitalo Countries like Singapore and HK run fiscal surpluses, making them more attractiveo Withholding tax on bond interest income waived off in many countrieso India needs to act fast when demand for Indian market is still lucrative



What the Opponents of this proposal will say?

o Rupee Appreciation a genuine concern for some sectors (And RBI)o Funding the rising fiscal deficits is the need of the houro Small price to pay for creation of market depth and long term monetary stabilityo First Step (Yet Again!) towards capital account convertibility and free float of rupee


Conclusion – In support for Proposal 2

Create the necessary policy infrastructure to make investing in bond markets lucrative

SEBI, RBI and Ministry of Finance need to be in congruence about their goals, locus

standi and degree of latitude

Create infrastructure for a robust derivatives market for debt securities on the lines of

equity markets

Enhance Securitization of debt securities. Provide incentives for private players to

compete with ARCIL

At the government level, ensure adherence to FRBM Act and make future borrowings

more rational. This will instill international investor confidence

Steps to achieve the full benefit of the committee's proposal


THE WORD IS NOT ENOUGH FOR BOND

INDIAN FINANCIAL SYSTEM – Group Presentation Class of 2013

THANK YOU

20

AASHISH AGARWALPRATEEK BHARGAVA

RAJATH HPRAMNATH SRINIVASAN

SRINIVASAN RAVISHANKAR

Raghuram Rajan Committee Proposal 2 Analysis-Indian School of Business

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