#30 The Name's Bond...Corporate Bond

Two-level games, FDI policy reversal, corporate bond market, and Farz

This newsletter is really a weekly public policy thought-letter. While excellent newsletters on specific themes within public policy already exist, this thought-letter is about frameworks, mental models, and key ideas that will hopefully help you think about any public policy problem in imaginative ways. It seeks to answer just one question: how do I think about a particular public policy problem/solution?


PolicyWTF: ‘The strong do what they can and the weak suffer what they must’

This section looks at egregious public policies. Policies that make you go: WTF, Did that really happen?

— Pranay Kotasthane

Economic nationalism is back and India is not to be left behind. The Ministry of Commerce & Industry reversed India’s FDI policy on 17th April, making it mandatory for all FDI coming in from countries that ‘share a land border with India’ to seek government approval. This policy applies to all sectors, meaning that even the next Bengaluru EdTech startup raising funds from a Chinese investor now needs the government’s aashirwaad.

Let’s look at the best form of the arguments given in favour of this reversal first. One, this will ‘curb opportunistic takeovers/acquisitions of Indian companies due to the current COVID-19 pandemic’. Two, Chinese investing firms have close links with the party-state. And three, if CFIUS (The Committee on Foreign Investment in the United States) in the US can block Chinese investments and if the UK can halt the boardroom takeover of Imagination Technologies by a Chinese investment firm, what’s wrong if India does the same?

Now let’s look at why this is a policyWTF. India’s economy is facing a severe demand + supply shock. Of particular concern is the unavailability of domestic capital for long-term projects such as infrastructure (one of the reasons for this is covered in the India Policy Watch section below). Without long-term investment, India cannot achieve sustained economic growth. And without sustained economic growth, India’s geopolitical options get majorly constrained. An economically strong India becomes an ideal counterweight to China for the US and also an ideal market for excess Chinese capital. In contrast, a weak economy will eventually be forced to throw its economy open to the highest bidder at any point of time (ask Pakistan). Given this key national interest, making it difficult for Chinese investments to find their way into India is extremely counterproductive.

It is true that there are no Chinese walls separating the investors from the party-state. And it would make sense if India were to block the takeover of a few strategic industries by Chinese firms. And India’s FDI policy is already equipped for this. To put an additional entry barrier for all sectors will turn away investors when India needs them most.

The general equilibrium effects of this policy will be as follows. One, investment from China into Indian startups will reduce. Two, more and more Indians will enlist their companies in more favourable locations such as Singapore. Three, unscrupulous Chinese companies with party-state links will still invest in India through shell companies in other countries.

Finally, let’s look at the argument that we should follow the stance that the US and the UK have adopted. This isomorphic mimicry makes little sense for India. The capital requirements of a 2000$ per capita income economy and a 64,000$ per capita economy will obviously be very different and so will our trade-offs.

The central foreign policy challenge for India is to keep itself open to all investments — including the Chinese ones — to build economic strength while simultaneously preventing the creation of a world order in which China replaces the US as the foremost superpower. Letting go of either of these objectives will perhaps be India’s biggest foreign policyWTF.

Some excellent articles on this topic:

  1. Swaminathan Aiyar makes the point that it’s really the other way around — it’s actually the foreign companies that take enormous risks when they invest in India.

  2. Swaminathan Aiyar, is again, at his best when he says ‘Apparently, alarm bells started ringing when Chinese investment in HDFC went up from 0.8% to 1%. In the name of Ram, Allah, Christ or Marx, how can you call that a security threat?’

  3. Sunil Jain writes ‘if India is to be more vigilant with Chinese investors, it must carve out no-go areas; without such rules, it will be impossible to ever clear Chinese investments in the startup world, which requires quick decisions on funding.’


A Framework a Week: Why Weak Dictators Get Softer Loans

Tools for thinking public policy

— Pranay Kotasthane

I’m sure you would have come across this argument that the 1972 Shimla agreement was a disaster because Bhutto got a far better deal even though Pakistan lost the war.

Except that this is not such an aberration. Robert Putnam’s landmark paper Diplomacy and Domestic Politics: The Logic of Two-Level Games argues that this is exactly what is more likely to happen: weak dictators can end up getting more favourable terms in international negotiations.

Putnam uses the framework of a two-level game to describe international negotiations. He writes:

The politics of many international negotiations can usefully be conceived as a two-level game.

At the national level, domestic groups pursue their interests by pressuring the government to adopt favorable policies, and politicians seek power by constructing coalitions among those groups. At the international level, national governments seek to maximize their own ability to satisfy domestic pressures, while minimizing the adverse consequences of foreign developments. Neither of the two games can be ignored by central decision-makers, so long as their countries remain interdependent, yet sovereign.

Here’s my illustration to describe this setup.

The politics of this setup operates as follows:

Each national political leader appears at both game boards. Across the international table sit his foreign counterparts, and at his elbows sit diplomats and other international advisors. Around the domestic table behind him sit party and parliamentary figures, spokespersons for domestic agencies, representatives of key interest groups, and the leader's own political advisors. The unusual complexity of this two-level game is that moves that are rational for a player at one board (such as raising energy prices, conceding territory, or limiting auto imports) may be impolitic for that same player at the other board. Nevertheless, there are powerful incentives for consistency between the two games. Players (and kibitzers) will tolerate some differences in rhetoric between the two games, but in the end either energy prices rise or they don't.

The key insight for me was this:

The political complexities for the players in this two-level game are staggering. Any key player at the international table who is dissatisfied with the outcome may upset the game board, and conversely, any leader who fails to satisfy his fellow players at the domestic table risks being evicted from his seat. On occasion, however, clever players will spot a move on one board that will trigger realignments on other boards, enabling them to achieve otherwise unattainable objectives.

India’s 1991 reforms can be understood using this framework:

Narsimha Rao and Manmohan Singh were able to use the rationale of external pressure at Level 1 (conditionalities imposed by the IMF) to water down opposition in Level 2 (domestic actors benefiting from the status-quo). The economic reforms were good for India in and of themselves, but the balance of payment crisis provided a political opportunity to execute them using the excuse of IMF conditionalities.

And so is the case with the Shimla Agreement. Bhutto was able to use the Level 2 game excuse (he would be kicked out by the Pakistani Army if the negotiation’s outcomes are seen as damaging) in order to obtain a far more favourable outcome at the Level 1 game.

Read the full paper for many more #TILs.

Bonus: I now think there’s a Level 3 game as well — the social media game between domestic groups of the two negotiating parties. Given that groups can talk to each other directly, such interactions often constrain what Level 1 and Level 2 negotiations can achieve.


Lights, Camera, (Policy Precedes) Action: Farz Chukana Hai

Public Policy via Bollywood

— Raghu Sanjaylal Jaitley

In his later years, Dilip Kumar often played an agent of the state (judge, police commissioner etc.) who would place his farz above everything else. In these roles, where he effortlessly blurred the lines between method acting and sky-high racks of piled up ham, Dilip Kumar would often shoot to kill or sentence to untold misery his own kin.

Shakti, directed by Ramesh Sippy, is the prime example of this genre. Dilip Kumar chooses to not pay a ransom for his school-going son at the start and in the memorable final scene shoots him (Amitabh Bachchan) as he flees from justice. The audience saw this adherence to farz as a strong personality trait.

But I have always argued that the farz of agents of the state stems from their incentives. It often used to be at odds with their personal values.  

The foundational premise of modern India is that the state is ontologically prior to the society. The state should create legislation and structures that shape and change the society. Its agents who emerge from that society itself have the incentives to adhere to the philosophy of the state regardless of whether it aligns to their personal convictions.

This created an unstable, yet desirable, equilibrium in India. The state was founded on values of equality, redistribution, secularism, fairness and social welfare. The society from where agents were drawn hadn’t fully accepted and internalised these values. So, you had free-market economists drafting socialist policies or an enlightened district magistrate who preached social equality at work but practised discrimination at home.

All good so long as the objectives of the state were met. An episode of Panchayat, a well-crafted series available on Amazon Prime, subtly drives home this point. The protagonist mildly threatens a village science teacher who believes in ghosts about how this will be viewed by the district magistrate who values scientific temper as mandated by the state. The teacher quickly confesses to having concocted the ghost story knowing it will hurt his career.

Incentives matter. Farz is about putting the right incentives.

The liberalisation in the 90s led to the creation of a large middle class that didn’t depend on the state for its livelihood. This freed them from the incentives designed by the Indian state. The free-market incentives aren’t the same as that of the state. It rewards efficiency and value creation. For the middle class now, there was no need to live the dichotomous life their parents led – of having a professional code that was different personal code. Liberals are often surprised how well-educated professionals working for MNCs turn out to be bigots. The answer is simple. The state couldn’t change the society as it had expected. And, once the incentives stopped mattering to the citizens, the mask dropped.

There’s no farz to adhere to because there’s no incentive.

You can argue the democratic mandate now is for the idea that the society is ontologically prior to the state. This changes the incentives for the agents of the state too. No longer do they have to align their ethics to that of the state. The state itself is being made to align its incentives to that of society. So, you have a scenario where both, those who depend on state and those outside it, have no conflict between their professional and personal codes.

If you believe the Indian state, as it was founded, aspired for ideals that were universal and virtuous, then you would worry about this alignment. On the other hand, if you agitated against the imposition of ethics by the state and the false dichotomy that served us no good and impeded our growth, you’d see this as a greatly needed transformation of the state.

Either way, don’t expect a Hindi film on the virtues of farz anytime soon.


India Policy Watch: The Shallow Waters of Corporate Bond Market in India

Insights on burning policy issues in India

— Raghu Sanjaylal Jaitley

Since the time I remember, India has suffered from two ‘depth’ problems. The reasons for the lack of lower order batting depth requires deeper academic research that’s beyond us. However, we can offer you a few pat insights on the easier problem – the reasons for lack of depth in the Indian corporate bond market.

Role of the corporate bond market

We are criminally short of infrastructure in India. Building roads, ports, power plants, airports need long-term patient capital and these companies should be able to raise it by issuing long-term bonds. Even otherwise companies would like to diversify their sources of capital so a crisis in one sector doesn’t put their project funding under risk. In the absence of a deep bond market, companies borrow from banks for the long-term. But banks have liabilities (deposits) that have a shorter horizon. This creates an asset-liability mismatch and defaults put immediate stress on banks to meet their depositor commitments. A large part of the systemic stress afflicting Indian banks is on account of this mismatch. Also, this leads to banks lending only to large corporates that have a track record with them over smaller or newer firms. For a country that needs an estimated Rs. 300 lakh crores of long-term infrastructure investment over the next twenty years, it is clear banks can’t be the only source of funds.

Often at this stage, a familiar question crops up. How did we build all the infrastructure that we already have? The short answer is the government created development finance institutions in the 60s and 70s (ICICI, IDBI etc) who issued bonds that were eligible to be counted among instruments that banks had to hold under statutory liquidity ratio (SLR) threshold. Banks earned a bit more than government bonds through these bonds and knew there was an implicit government backstop because another PSU was borrowing money and building the infrastructure projects. But there was a limit to this kind of arrangement as we liberalised and private sector came in. Eventually, these institutions were privatised, and they turned into universal banks.

There’s no shortage of evidence about the shallowness of our bond market. The size of the corporate debt market (16-17 per cent of GDP), the low daily trade volumes (0.2% of total), the lack of a mature debt ETF (Bharat debt ETF is a good start) and the absence of a market for below AA-rated paper which primarily gets traded in information-intensive and bilateral private placements all point to it.

Where’s the depth?

Let’s look at the demand side first. There are financial instruments like insurance and pension plans that mop up funds from savers with long-term investment horizons. These funds should ideally invest in corporate bond markets. The long-term nature of their investments and the large pool of savings they accumulate allow them to take the occasional risks of defaults in their stride. The other instruments like bank FDs, debt MFs and small savings schemes have shorter horizon with redemption options but can have a large part of their assets invested in the bond market. Of late, foreign portfolio investors are also participants in the bond markets. On the supply side, there are corporates who need access to long-term capital for various projects that might be rated below the highest grade on credit risk.

Despite these there are both liquidity and depth problems for a variety of reasons:

  1. Financial repression: Most institutional investors (pensions, insurance and MFs) have prudential norms for investments. Simply put, the regulators ask them to hold a large part of their portfolio (over 50 per cent in most cases) in central and state government securities. Similarly, banks have SLR requirements to hold government securities. These are the way for the government to channel retail savings to fund its fiscal deficit every year. This is financial repression and while this has been coming down over the years, it crowds out other instruments and keeps interest rates low for investors.

  2. Absence of a market for securities rated below AA: If you are a pension or insurance fund manager, you want to invest in long-term instruments but without the risk of investing in lower-rated paper. However, most private long-term infrastructure projects won’t be AA rated. There’s a conundrum. In mature markets, this is sorted by a market mechanism where a higher rated intermediary (like an insurer or a bank) backs the lower-rated security and underwrites its risks. The instruments used for this are credit default swaps (CDS, where an insurer takes the risk of default for a premium) or credit enhancement or guarantee mechanism where banks back the bond issuer to meet its repayment commitments by offering credit lines or acting as a backstop, thereby boosting their ratings. In India, there’s no CDS market because of certain regulatory restrictions on the netting of mark-to-market positions. The credit enhancement and guarantee funds have been proposed by the government, but they need active support.

  3. Liquidity: Most bonds are held by pension or insurance funds until maturity without any means of being traded. The lack of liquidity deters issuers from entering the corporate bond market. Also, there’s a role for a market maker in reducing the transaction costs for a debt repurchase agreement (repo) between the borrower and lender. This arrangement called tri-party repo reduces the friction of multiple bilateral arrangements and aids trading of securities. India has introduced tripartite repos a couple of years back. It will help to have more tri-party agents like banks and brokers and freeing up the norms for collaterals to include high-quality corporate bonds too.

  4. The reluctance of retail investors: Retail participation in the corporate bond market is only about 3 per cent. There are multiple reasons for this. The tax treatment of debt MFs and their dividends are unfavourable when compared to equity MFs. There’s no easy way for retail investors to invest in bond markets through digital platforms. There’s also the ‘anchoring’ effect which keeps the bank FDs and small savings rates high in India. Our historical view of these rates and the political ramifications of reducing them (what will happen to ordinary savers, senior citizens etc?) have a negative impact on developing fixed income asset classes.

  5. Supply-side issues: Government has nudged SEBI to issue guidelines that force companies that are AA rated and have loans more than Rs. 100 crores to compulsorily raise 25 per cent of their debt through bond markets. This diktat model can be accepted for the short term to increase issuance in the bond market, but it has its own flaws. First, raising debt from bond market is costlier than taking a bank loan for AA and above rated securities. There are additional reserving requirements and there are the transaction costs of issuing bonds. Second, the disclosure needs are high, and corporates are happier doing private placements that are opaque to the rest. The private placements account for almost 95% of corporate bonds issued every year. This further reduces the liquidity in the market. Also, more than 80 per cent of outstanding debt securities are issued by financial corporations (mostly NBFCs) which are subscribed to by banks and exacerbate the maturity mismatch problem of banks. Lastly, there’s the option for large corporations to raise debt through external commercial borrowings (ECBs) which tends to be cheaper even adjusting for currency risk hedges.

  6. Infrastructure: The debt market trading infrastructure including the platform, the ease of access and the ability for electronic bidding platform to manage parallel issuances from one issuer are all measures that need to be worked on. The difference in trading infrastructure between equity and debt markets is stark.

  7. Risk perception and market awareness: The Insolvency and Bankruptcy Code (IBC) is a good measure that provides guidelines for resolution in case of a default. Speedier resolution of bankruptcy proceedings and preference given to senior creditors will provide assurance to investors to enter the bond market. The financial sector isn’t covered under IBC while it accounts for over 70 per cent of bond issuance. The not infrequent collapse of shadow banks doesn’t inspire confidence and it is important to pass the Financial Resolution and Deposit Insurance Bill to cover this. Also, the credit rating agency and the regulators should increase awareness about the bond markets among investors. The significant infrastructure deficit can only be funded by getting more investors to come in and mobilisation of capital through the issue of corporate bonds  

These aren’t issues that are unknown to policymakers. But, as is usual in other spheres of policymaking in India, we are either to slow to make the changes or there are misaligned incentives that work at cross purpose to the reforms efforts put in here. The great Indian march, two steps forward and one-and-a-half step back, continues to bedevil the corporate bond market.


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