On 18 August, the Reserve Bank of India (RBI) published the working group report on the development of a corporate bond market in the country. Without fanfare, some of the areas in which actions were due from RBI were announced a week later. These are profound changes. It allowed banks to offer partial credit enhancement up to 50% of a bond issue from the present 20% and RBI proposing to accept corporate bonds as collateral under the liquidity adjustment facility are likely transformational.

These are desirable and they constitute the necessary conditions. Ultimately, the ball is in the court of companies that wish to borrow. If they embrace the bond market, they will also have to embrace better corporate governance and transparency in reporting. In this regard, the sooner India’s accounting standards converge fully with International Financial Reporting Standards, the better. What is happening in India’s capital markets now is epochal change and the Institute of Chartered Accountants of India should recognize that.

Further, in its announcement, RBI indicated that banks would be permitted to issue ‘masala’ bonds (perpetual bonds or perpetual debt instruments) for meeting additional Tier-I and Tier-II capital requirements. This was not part of the H.R. Khan committee report and it is a significant step. RBI has taken a big step towards finding additional Tier-I and II capital for banks. Andy Mukherjee of Bloomberg has noted that these moves could cause a positive reappraisal of the legacy of the outgoing RBI governor, Raghuram Rajan, who has been accused, unfairly, of making life difficult for borrowers and lenders.

On the same day that RBI announced the above measures, it also released the draft framework for banks’ large exposures to corporations and corporate groups. Under the framework, banks will have to set aside more capital for exposure to a particular company or a corporate group. It would dissuade banks from lending more to them, sending corporations to the capital market to borrow. This could prove to be a very significant step in many ways. It attacks crony capitalism. It eliminates a big source of banks’ non-performing assets. It forces banks to learn to assess credit risk and lend to borrowers whom they have shunned so far instead of engaging in lazy lending to large borrowers.

Now, it becomes logical to demand and to anticipate a reduction in the statutory liquidity ratio (SLR) for banks. After all, SLR was needed at a time when the government of India needed captive buyers for its bonds. A market might not have been available then. But, times have changed and how! With zero and negative rates of interest in the developed world, there would be ready takers for Indian government bonds that would carry a nominal coupon of 6% to 8%, depending on the Indian inflation rate. This situation will be with us for quite some time and even for quite a long time to come.

If that happens, banks can direct their credit to medium and small enterprises instead of replacing loans to their corporate customers with Treasury bonds. The incoming RBI governor, Urjit Patel, will likely push for it. He had written eloquently on the tendency of public sector banks to seek the safety of government bonds whenever their non-performing assets begin to rise, constricting credit flow into the private sector. In the process, as he had noted in his paper, they had left profits on the table.

Indeed, the problem may not be inadequate demand but too much demand for Indian debt. The private sector too and not just the government should be on guard against being carried away by it. In theory, the exchange rate risk under masala bonds is borne by the investor and not by the issuer. In that sense, they are not ‘external debt’ strictly speaking. The currency of denomination of the debt is the Indian rupee. However, the currency risk is not fully eliminated. That should not be lost sight of.

To the extent that the base currency of investors is not the Indian rupee, the exchange rate risk at a macro level for the country remains. If they take fright or if they decide to seek the safety of their own currencies for any reason, there will be pressure on the rupee. So, masala bonds eliminate currency risk at the micro level, but not at the macro level.

That said, there could be no doubt that masala bonds are a welcome development. It familiarizes overseas investors with the Indian economy, Indian borrowers and with the Indian currency. India is internationalizing its currency quietly. That is to be applauded, especially when offshore renminbi deposits are dwindling and internationalization of the renminbi has slowed, if not reversed.

Let there be no doubt that the past few months have witnessed a steady onward march of right policy measures that enhance India’s potential economic growth rate and eliminate barriers to financing the enhancement of potential growth.

From bankruptcy code to goods and services tax to elimination of capital gains tax advantage to Mauritius-domiciled investors to reviving the corporate bond market and the launch of the unified payments interface, a lot has been and is being done. They deserve our unreserved praise.

V. Anantha Nageswaran is an independent financial markets consultant based in Singapore.

Comments are welcome at baretalk@livemint.com. To read V. Anantha Nageswaran’s previous columns, go to livemint.com/baretalk

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