RBI's corporate bond mkt reforms: 'Mini bang' and what's left

He may have a week left at RBI, but Raghuram Rajan has managed to fire another reform salvo – a bunch of steps to broaden and deepen the corporate bond market last week. It has allowed banks to provide up to 50 percent credit enhancement to bonds. The RBI has moved the government to amend the RBI Act so that it can accept corporate bonds as collateral in its repo window.And there were more steps: banks can issue rupee bonds or masala bonds in foreign markets to raise capital and to finance infrastructure and affordable housing primary dealers will be provided finances to make market in illiquid government securities, foreign institutional investors (FII) can now directly buy or trade in government securities (G-Sec) market, and in the foreign exchange (Forex) market, companies can hedge up to 30 million dollars with very little documents and they can keep open positions of USD 5 million, something that has never been allowed before.In an interview with CNBC-TV18, Former RBI Deputy Governor HR Khan, who headed the panel that recommended the slew of reforms, along with HSBC India's Head of Global Banking and Markets Hitendra Dave and Axis Bank's Deputy MD Srinivasan Varadarajan, talked about the announcements and what steps the central bank should take to further boost the market.Below is the transcript of Srinivasan Varadarajan, Hitendra Dave and HR Khan’s interview to Latha Venkatesh on CNBC-TV18.

Q: What was so game changing about the bond market steps?Varadarajan: As you said, it is some sort of a mini bang and clearly we have made good progress on a lot of fronts. While you called it reform in the corporate bond market, if you look at each of the measures, the biggest in my view which is to some extent game changing is the Forex side actually. Doing USD 30 million without underlying and a USD 5 million open position across corporates and the number of corporates we have and what they can do in terms of USD 30 million without underlying makes things very simple for a huge cross section of corporates. And that, in my view, is the biggest reform as far as this package is concerned. Though the focus in on corporate bonds, tactically, the forex reform there has clearly some game changing attributes.Q: What would your thought be? I take your point that this is providing huge liquidity to the markets. Hopefully, there will be two-way views from corporates. But in the corporate bond market itself, you do not think this has any game changing attributes, like that forcing corporates to get into the bond markets because banks tap will close?Dave: No, absolutely. I frankly think a lot of us have participated and it tends to divide and deepen, make the corporate bond market more vibrant. We have all struggled and we have all given a list of issues that need to be done and frankly, you have to give an enormous amount of credit to the committee and Mr Khan himself for covering almost every aspect that anyone thought is needed to make the market more liquid. We have so far seen only the measures announced by the Reserve Bank of India. That report also lists a lot of measures that are needed to be taken by the Securities Exchange Board of India (SEBI), by the government of India, by Pension Fund Regulatory and Development Authority (PFRDA), Insurance Regulatory and Development Authority (IRDA), etc. but the number one thing is that corporate bonds, unlike in other parts of the world did not have the ability – you could not refinance those. If you went to a bank to borrow against a bond, you got the money at a marginal cost of funds based lending rate (MCLR) or a base rate as the case might have been and invariably, that is much higher than the yields on the bonds. So, the fact that you have generated refinance or leverage, it really is a phenomenal step. And taking a step further, I really hope that when they finally announce the liquidity adjustment facility (LAF) guidelines on what kind of bonds are available, I really hope they try to make it slightly more liberal. I know this is really pushing central bank boundaries, but AAA rated bonds are not where the problem in India is. The problem in India is, as you go down the curve to AA, A+. This is all investment grade stuff.So, if you see once again the report which has said rating agencies can tap information from the Central Information Commission (CIC) and if that information is available, the confidence of investors will increase and if those lower rated bonds -- albeit with credit enhancement -- are eligible for some form of refinance through regulated entities or through market repos which then go into the regulated entities, it can actually be quite a gamechanger. We have to gain something big here.Q: I am almost sure that they are not thinking down that curve. At the moment, it is only AAA, I am privy to that information. Generous praise from Hitendra Dave, but he pointed to that rating agency. Do you not think that there was some glaring omissions from your panel report? For instance, exactly this: rating agencies should be given access to the Central Repository of Information on Large Credits (CRILC) and they should know the list of Special Mention Accounts (SMA)-II accounts, people who have defaulted in 60 days that they should make weekly disclosures regularly. Are you not a little upset that some of these low hanging fruits were not implemented?Khan: No, quite a few things. Let us look at it this way. There are few things which have been announced which are in the RBI domain, they have been announced. Few things are still in the RBI domain, we have to work further. One example is what you mentioned about credit rating agencies being allowed to CRILC. There are legal issues involved there, so it has to be examined. So, that is one. The other thing is that there are some good practices which they are required to follow. For example, on quarterly basis, at more frequent basis, they should disclose what has happened to the rating. So, SEBI will take action on that. And similarly, there are recommendations which would come under the SEBI domain, the government domain. For example, the stamp duty part, government has very seriously seized that. So that part will come.So, I would not say that in one shot, everything is done and there is nothing else to be done. It is a process which has started and the other one which we had very strongly mentioned about credit default swaps (CDS) is the netting aspect. There is no specific point in this press release, but as I mentioned, it has to be examined because whether it can be done under the existing legal framework based on legal opinion or amendment has to be moved.Q: One would have expected netting of derivatives. Even that netting was not announced. Khan: Netting is very crucial, not only for CDS, but a whole host of derivatives.Q: Is that a very big issue? Netting of derivatives, does it require legal changes? Is that why it did not come?Varadarajan: India is still not a netting eligible jurisdiction, as they call it and therefore, in terms of market participants, providing capital will be on gross basis and to that extent, there is an issue in terms of how exactly, and there are case laws in terms of whether you can net payables versus receivables._PAGEBREAK_ Q: At the Foreign Exchange Dealers' Association of India (FEDAI) meeting, was there not a commitment given that those legal changes will also come?Dave: In the Khan Committee report, it is specifically mentioned that this aspect needs to be looked into as Mr Khan is mentioning. Also, even the Governor in the remarks yesterday has actually mentioned that this is what we have done, this is what is in the pipeline. So, I am assuming that almost all the committee recommendations are likely to be accepted going by the evidence on record for the last two days. And therefore, if you see the totality what will happen, you will have electronic platforms, you will have Delivery versus Payment (DvP), DVP-III introduced for corporate bonds, you will have potentially credit rating agencies joining the membership of CIC or whatever the legal issues that needs to be sorted out. If you see the totality of all of these, you are effectively saying rating agency is not only going purely by future projections, it will actually have access to live data. That is a very material confidence booster, especially when you are trying to widen participation in bond markets.Q: It is very clear that corporate bonds are going to be accepted by RBI - that legal changes are coming. If that were to come and even assumingly started with AAA bonds only with haircuts. You think it is a substantial push as Hitendra says?Varadarajan: Funding, when you get at much cheaper, basically when there is positive carry. Right now if you are borrowing deposits and other source of funds investing in corporate bonds to some extent in the high rated bonds you could end up having negative carry. If that is cut out like in government securities (Gsec), the ability to hold over a slightly longer horizon increases. As Hitendra is saying, I think the investors side reform also should happen to make sure that the market... you are increasing the ability for people to hold intermediaries -- you are increasing the supply side. Now how do you increase the demand side and that is also an important thing because if supply increases, intermediaries hold but if ultimately the demand doesn't come through the system chokes up. I think everything has to happen and the demand side also needs to get going. Q: Coming to the other big announcement that came last week on the large exposures and the fact that starting 2018, banks will not be able lend more than 50 percent of outstanding loans to some of these big groups. Above 25,000 crore would be a lot of companies and groups. If that were to happen, is there enough steam in that proposal to expand the bond market maybe even the junk bond market?Dave: The committee or the RBI has obviously seen it in its totality. You have to recognise that the banking system is the dominant provider of financing to the corporate world. You cannot simply say we will not do so from 17-18, 18-19 and 20-21 and 20-21 is something like Rs 10,000 crore - that is an amount which is fairly sizeable population of corporate would fall in. Therefore, along with that this partial credit enhancement has been increased. You got to see it in totality and therefore when I was talking about - I hope RBI in drafting in its own liquidity adjustment facility (LAF) guidelines, at least bonds guaranteed by their regulated entities - are they eligible for LAF or not.I read the guideline where it suggests that banks are not expected to buy bonds credit enhances by other banks. So the intention is to diversify risk away from banks and therefore if you have - to Srini's point - if you have intermediaries who are not banks and not PDs, who have bought these bonds.What you need is the private repo market where they can repo possibly counterparties being banks and PDs, who can then refinance at -- the private rates market will be the private rate markets and it can sometimes be above the policy rate. What you want is a certainty that you refinance at close to policy rate from the monetary policy authority and therefore that chain -- established that regulated entities can undertake repo and private repo markets or the electronic platforms. Once they acquire certain collateral - that collateral which is eligible to refinance once again with RBI, will naturally then get and I certainly hope as a starting point apart from AAA, it's understandable AAA as a starting point. But I would go a step further and say if you have 50 percent credit enhancement from your own regulated entities, is the lender of last resort really taking any genuine credit risk and we are talking about overnight and two days here.Varadarajan: One thing is that looking at Rs 25,000 as a limit to start with; we should not confuse entities with groups. The number of entities who will have banking system exposure in excess of 25,000 crore, is just going to be less than a handful. I don't think it will be more than the numbers. So to that extent it is a slow process in which they are guiding large entities to -- the Rs 10,000 crore -- probably by FY20 it will be just over billion dollars. So that could be a larger number and by which time the bet is that the market is open enough to absorb that supply.Q: What is your take? Today, there is no term money market, no connection between the debt markets and the banks setting the lending rate. They do it according to their deposit cost. Do you see any steps from RBI to ensure that these two markets talk to each other so that loans are priced according to the debt market?Khan: Let me put a bit of context to this. It is always cart-before-the-horse or chicken-and-egg type of situation -- in that which should come first. One major area where corporate bond market requires a driver is market-making. So, who will do the market making in corporate bonds? Banks are already buying, primary dealers (PD) have been allowed quite a bit of leeway, but they have their limitation because their major responsibility is G-secs. And in the press release, another major game changer is that for a long time, we are waiting for this market making in government bonds for PDs, so some framework has now been agreed upon. So, now government and RBI work that is going to put. But for the corporate debt, really the PD cannot go to that extent. So, there are brokers who can do it, but they need some liquidity and funding support. So now they will be allowed market repo access in the corporate bond paper. That is step number one.The other thing is, we have mentioned about tripartite repo because that is also another part which will expedite. And next in line will be the acceptance of corporate bond under RBI’s LAF window. So, that could be the sequence. But if you talk about RBI LAF, we have to see it slightly in a overall perspective. There are positives, there are risks involved. Positive is that it will provide funding support, liquidity will be added. RBI has another asset class and you give a nudge to this whole market directly and indirectly. But the negative part as some of the commentators have mentioned that we carry the credit risk and we will only be focusing on AA and AAA and again segmenting the market. After doing all that, if market does not take off, then reputation risk. But at some point of time, one has to take some bit of risk and take it forward. That is why we have suggested that to start with, we can probably do it for overnight basis, maybe for AAA, AA paper and with some adequate haircut. So, this is something an enabling thing which will provide some sort of a nudge to the market. That is the background._PAGEBREAK_Q: Do you think infrastructure projects will get money? If you have a Rs 25,000 crore ultra mega power project (UMPP), how will it get funded in 2018, 2019?Varadarajan: One thing we should appreciate is that the corporate bond market we have today and at least in the slightly medium term, 2-3 years is still going to be continued to be a high grade market which is a AAA or AA market. And that is unlikely to change unless you have huge amounts of high yield money coming in to funds which I do think is a focus. So right now, fixed income is an asset class which is marketed as something you get and yield pick up over sovereign and it is safe and secure and therefore, there is no credit risk there. So this is a high grade market. So if you are looking at project financing being achieved through capital markets, the partial credit enhancement route is the only way to go. And that is something which is extremely positive. But whether, even on a plain project finance, with the credit enhancement, you will have a market which takes off, we will have to see.But the partial credit enhancement which has been allowed right now is an extremely useful tool in terms of allowing access to corporates who otherwise will not be high grade. And that is extremely positive. Just to answer other questions in terms of loans versus bonds, the biggest thing for corporates today is that if you are borrowing 10-year money or 5-year money, irrespective of the level of interest rates, I do not think a corporate is keen to lock in to a single rate whereas a bank, it continues to be floating. And the bank product offers a lot more flexibility in terms of prepayment, pricing, whatever. You have a huge amounts of flexibility there.So even if you look at the best of corporates, if they are doing project finance or if they are doing long-dated financing, locking into a fixed rate is not going to be easy for them. So, unless you have the other markets available, for them to swap back into floating in some form, it is still some work to get done on that front.Q: It is ideal to ask who will buy the infrastructure paper. It should be the PFRDA. But all of us, in probably 10 years time will be wanting our pension money, will you be happy if our pension funds are locked in infrastructure bonds given the state of the legal system?Dave: I would like to think that once you have supply, it will create its own demand. We have seen bonds issued as recent as just last month at coupons of between 9-10 percent and the response has been overwhelming. And this is largely from retail and high networth individuals. So, I do not know a project which is rated at A or even BBB and if it comes with a coupon of, let us say in the current context, might be 12 percent or so. Whether that generates its own demand and if that is partially guaranteed by banks and therefore it has got to a rating where it is double digit coupons in the current interest rate context, how much money has not come because the pricing has not ever been available. My own sense is that given what has happened to the inflows of money into equity, credit funds, income funds, etc. increasingly, even the Indian saver is quite open to taking risk, but almost so far, we have not even been allowed to take that risk. So, it is again, as Mr Khan said, a bit of chicken and egg situation. So, once the assets are available and which is what RBI has mentioned that we are creating the supply, we are creating the infrastructure and the assumption is that the demand will follow and beyond this, I am not very sure what else as a market we can ask for. And this is quite good in that sense.Q: I believe the RBI has done its level best to push under the circumstances, but my fear is that unless we get our legal piece right, this corporate bond market cannot go beyond a point. Since you have already retired, will you put your pension money into any of the infrastructure bonds until the legal piece is right, can this corporate bond market really take off like it should?Khan: Again chicken and egg conundrum. They have justifiable apprehension about credit quality, defaults and all that, so once you have a more and more liquid market, robust market, those apprehensions will come down. Similarly, for CDS, in a more matured market, long-term players like insurance companies are the CDS sellers because in the long-term, they know that long-term space. But here because market has not developed, they are apprehensive. So, they have their points. We need to work on that. Once the market develops, they will probably have a little more comfort to be a little more relaxed.