Let me illustrate this by comparing the US with India. I run an India focused investment fund and have spent the last decade researching and analyzing the Indian markets. India has a very sophisticated and well developed equity market - comparable with the best in the world; however, the debt markets in India are underdeveloped. The US on the other hand, has the largest, deepest and most liquid debt market in the world.
Why has the debt market failed to develop in India? Debt markets deal with fixed income securities that offer defined payoffs to investors over a defined time period. The risks inherent in debt markets are of two kinds – credit risk or default risk and interest rate risk or duration risk.
Interest rate risk arises from changes in the opportunity cost of capital among various market participants between the time a fixed income security is issued and the time it is completely paid off. This is a risk that originates in the hands of the holder of the security (for the most part). If a country has an efficiently functioning market system, where trades are settled and where the clearing system ensures protection from default by individual market participants, this risk is handled well by the market place.
As discussed earlier, India has a well functioning capital market with robust institutions that ensure the smooth functioning of exchanges and clearing houses. India, therefore, also has a well functioning government bond or securities market. This is the only part of the debt market that carries no credit risk and only carries interest rate risk. The Indian government routinely runs budget deficits of 3-5% and the shortfall is met through borrowing in the domestic government securities market.
The corporate debt market (even for the highest rated corporate) has failed to take-off. The government in India has issued numerous discussion papers and has demonstrated its intent to develop the corporate debt market. However, the reason the market has failed to take off has nothing to do with the availability of capital or the existence of securities and market instruments. It has everything to do with the strength of the legal system in India and the existence of strong bankruptcy, insolvency and receivership laws and the effectiveness of their speedy and smooth implementation.
The corporate debt market deals with credit risk in addition to interest rate risk and it is in the case of the former that India is found wanting. What is the challenge?
Debt by definition is senior to equity. Within debt, there are securities that are structured as senior and others that are residual in nature. When the going is good and all securities are paid off, the returns to each security holder are well understood. What happens when things go bad and a company or a special purpose entity is unable to meet all its payment obligations holds the key to the development of a vibrant debt market.
We in the US, take it for granted that if a company is not able to meet its debt obligations, the company will have to file for bankruptcy where all the equity is written down and where residual assets are either liquidated or reorganized and allocated to different claims (societal, employee, crown and private debts) in their order of seniority. While the process can be laborious, lengthy and prone to high accounting and legal fees, the process works and follows the rule of law.
This is not the case in markets like India. Let me share an anecdote. I was in Switzerland earlier this year for a conference and I met with an interesting individual who shared his experience about investing in India with me.
In the frenzy of all things emerging market in 2006-2007, an interesting market called the foreign currency convertible bond (FCCB) market developed for Indian companies. These were bonds issued in foreign currency by Indian companies and sold offshore with embedded options for conversion to equity at pre determined premiums. In the go-go bull market of the time, investors lapped them up because the 3-5 year options seemed like no brainers to investors. For issuing companies, the benefit of lower interest rates on current debt with the potential conversion at a premium to equity at a future date seemed too good to pass up as well. Billions of dollars worth of FCCBs were issued by several Indian companies and absorbed by foreign investors.
As we know, the story got very interesting with the financial market collapse of 2008-2009. Stock values plummeted deep out of the money (in reference to the convertible option prices on the FCCBs) and the prices of the bonds themselves lost more than half their value.
This individual who I met in Switzerland told me that in July 2009 he purchased about a million dollars worth of FCCBs of an Indian company at 60 cents on the dollar. The total issue size was 10 million dollars and the bonds were due for maturity in June 2010. In his analysis, he found that the company had 50 million dollars of cash and no other meaningful debts to speak off.
During all of 2009, investors in the FCCB market remained in a state of panic. They eagerly negotiated settlements with issuing companies and many of the bonds were redeemed by companies (or bought back) at 50-60 cents on the dollar. This obviously sent signals to the solvent company in which my new acquaintance had invested that they somehow did not need to repay the entire debt outstanding. So when time came to pay up in 2010, this solvent company with a robust equity market capitalization indicated default and chose to enter negotiations with debt holders.
My acquaintance flew to India during this time and threatened legal action on the CEO. The CEO chose not to antagonize him and paid him in full. However, he paid only 60 cents to him officially (the amount he had negotiated with all the other holders) and paid him the remaining 40 cents under the table.
This story really blew my mind. But this story is only the symptom of the disease. The disease itself is that Indian law and Indian courts do not accord sufficient sanctity to a private debt held by a private (non-bank) entity. The laws in India are written to almost exclusively protect the interest of banks that lend to private entities secured against collateral. In fact, until the securitization of collateral (SARFESI – Securitisation and Reconstruction of Financial assets and Enforcement of Security Interest) act was not passed in 2002, even a bank had to struggle through years of litigation before being able to enforce foreclosure on collateral offered against a defaulted loan. With the enactment of SARFESI, lenders secured by collateral (limited only to banks and recognized domestic financial institutions) could enforce their security interest on a defaulted loan without going through the judicial system.
How does the existence of a vibrant debt market benefit the US economy and how does it harm the Indian economy. The entire Indian economy is dominated by the commercial banking system. The banking industry is dominated by government owned banks, which although very well run, are effective oligopolies. India is one of the few places left in the world where banks are able to earn net interest spreads of 3 – 4% on their loan books and are extremely profitable in their plain vanilla deposit accepting and loan making business.
The usury by the Indian banking system exacts a huge toll on Indian companies (borrowers) and significantly reduces the efficiency of the Indian economy. With the exception of the 50 largest corporations in India that are large enough to be rated externally and borrow in foreign currency internationally, all Indian companies are dependent on the banking system for their debt financing requirements.
The US debt markets allocate capital very effectively and creditworthy borrowers are able to raise debt resources on very competitive terms. Even non-creditworthy and high risk borrowers are able to raise resources (albeit at high cost) to enable them to undertake their high risk (in aggregate adding to the vibrancy of the US economy) ventures.
The developed and deep financial markets are therefore a vital asset to the US economy. Unless, the government in India (and in other emerging markets) are able to put in place the structural changes required to their legal and regulatory systems and ensure their effective implementation, their debt (and hence capital) markets will remain underdeveloped, placing their corporations at a disadvantage to those domiciled in economies with developed capital markets.
As a money manager and seeker of low risk high return opportunities, I am always on the lookout for opportunities that peculiarities/distortions create. While I am not a huge fan of hyper-leveraged entities (definition of a bank), the possession of a banking license in India is a license to print money. Unless a bank in India is completely reckless and colossally stupid, its ability to lose money in aggregate over time is low. In that context the Indian government owned banks are still misunderstood and under-rated; they provide an opportunity to earn outsized returns over time.
The two black swan risks they carry, however, are firstly a complete deceleration and deterioration of the Indian economy for an extended period (which will result in a mushrooming of bad loans and complete collapse in collateral values) and secondly the coming-to-senses of the Indian government and the enactment and implementation of sound laws and regulations that lead to the creation of a vibrant and large corporate/private debt market that would then erode the oligopolistic positions of Indian banks.
From my vantage point, I believe that the probability of both is very low (albeit not zero).
The rest of the world has learnt a lot from the economic models developed and perfected by the US. Most economies have a long way to go before they develop the institutions, regulations and talent required for the development of efficient financial markets. Until then, the US will remain the destination of choice from users (borrowers) and providers (lenders) of capital.
Until that happens, the Indian state owned banking sector offers an attractive investment opportunity to those willing to put in the time and effort required to identify the winners from the losers.