A brighter future?

For much of the past decade, the Indian economy has been booming. But while India has not been as severely hit by the credit crunch as many other countries, it does now face serious economic difficulties. Lack of credit and liquidity in the market is causing severe problems. And companies' reliance on Foreign Currency Convertible Bonds has stored up an imminent crisis in the corporate sector. Abizer Diwanji argues that one of the keys to unlocking recovery will be government funding of infrastructure development and making the corporate bond markets in India more attractive to investors.

Since the millennium, India has been seen as one of the key growth countries among the developing nations - the third part of the BRIC (Brazil, Russia, India, China) quartet, whose dynamic new economies were set to challenge the developed world over the coming decades. From 2002, India's economy has grown by an average of eight to nine percent per annum. The financial system has been progressively liberalized, and the country has been increasingly integrated into the world economy.

During this time, the stock market boomed, corporate profits multiplied and foreign direct investment soared. Demand for the rupee drove up the exchange rate. Many politicians and business leaders grew accustomed to continuous growth and rising prosperity, and looked to them to steadily alleviate the continuing problems of inadequate infrastructure and rural poverty.

Despite the boom, India is still far from becoming a modern advanced economy. The financial sector remains comparatively over-regulated. Securitization is limited. There is a very small and illiquid corporate debt market. Banks have historically been generally wary of excessive credit risk. Regulations that require Indian Banks to hold government bonds have meant that while bank balance sheets have been strong, this has not translated into commercial lending: by comparison with banks in Europe and the US, with typical loan-deposit ratios of 100 percent, Indian banks have had ratios of 45-48 percent. Half of depositors' cash has been locked up in government bonds.

In some respects, these characteristics have helped to shelter the Indian economy from the worst of the global crisis. With little exposure to complex structured products, the financial sector has been shielded from the Collateralized Debt Obligation (CDO) subprime disaster. There is a much smaller toxic asset problem. Nevertheless, the country is far from immune to the crisis. So far in crisis, the stock market has fallen by 50 percent, and the rupee has fallen significantly against other major currencies, mainly as cash has flowed out of the Indian equity markets to fund losses in home countries.

Other aspects of the Indian financial market have led to further challenges, in particular the limited market for corporate debt. Because companies in a rapidly-growing economy could not borrow easily at home to finance expansion, they relied increasingly on foreign capital and on equity issuance. A lot of 'hot' money flowed into the Indian stock market; private equity became a major source of funding outside of stock markets.

A particularly notable feature was the development of Foreign Currency Convertible Bonds (FCCBs) as a vehicle to attract overseas funds. As the name suggests, these are debt instruments denominated in a non-rupee currency which also give the investor an option to convert the debt into equity at a future date at a significant premium to prices on the date of issue. Companies got cheaper funding with lower dilution as conversion was considered inevitable given the consistent rise in stock prices. FCCBs were attractive to investors as equity conversions offered higher returns than conventional debt. Further, there was always a redemption option with back interest if the conversion option was not exercised.

However, all these attractions assumed that stock prices would continue to rise and that FCCBs would be converted to equity. The collapse in the stock markets has scuppered this, destroying the value of conversion. Instead, issuing companies are faced with the prospect of paying interest on these bonds along with redemption of principal when they mature. Since some estimates suggest that Indian companies have issued up to US$20 billion of FCCBs over recent years, with none of the corporates planning cash flows for redemption, this could lead to increased defaults in coming years.

As the crisis has taken hold, profits have evaporated; many exporters have been hit; industrial sectors such as automotive, cement and real estate are suffering from significant contraction in demand. The already tight credit market is being further starved as many banks become even more reluctant to lend.

The Reserve Bank of India has taken a series of steps to try to free up the market and inject liquidity. But although banks now have greater liquidity, this is not necessarily finding its way to private industry. One major route to getting the economy moving again could be government investment in infrastructure development. Years of low investment have left India with crumbling roads and transport infrastructure and inadequate public utilities. The government has previously estimated that US$500 billion needs to be invested up to 2012 to improve the country's basic infrastructure. Originally, it was hoped that foreign capital would contribute a substantial tranche of this. Now, this is unlikely.

However, direct funding is not an option given a high fiscal deficit. The Government should seek to provide appropriate guarantees to cover the credit risk of large infrastructure projects. Banks would then be incentivized to fund infrastructure demand. Core infrastructure funding could also help develop demand in commodities and ancillary infrastructure related services. A demand push in industry would ensure banks start lending to corporates again. This should restart the cash flow cycle.

Finding a way out of this infrastructure investment trap will be a key priority for the new Indian government. But if it can be achieved, the benefits in stimulating the economy across all sectors couldbe immense. It is not as if the economy is in the doldrums: forecast growth of 6 percent in 2009-10 compares handsomely with the position in many western countries. Once the current cycle turns upwards to greater easing of credit and liquidity, there is every chance that this particular BRIC economy will boom once more.

Article author

Abizer Diwanji
Executive Director
KPMG in India +91 22 3983 5301 Abizer Diwanji View all articles by this author