Speeches

Unlocking Long Term Finance To Renew Growth

The Finance Minister of India, the Honourable P Chidambaram

Distinguished Guests

Ladies and Gentlemen

1. It is privilege for me to be here for SEBI’s Silver Jubilee.  It is in retrospect truly impressive how a calibrated series of reforms over 25 years has created a modern and thriving capital market that is playing a key role in India’s economic ascent. This is to the credit of the successive chairpersons, management and staff of SEBI.

2. SEBI has also played a leadership role in international standard-setting in capital markets. I know about this because the Monetary Authority of Singapore (MAS) works closely with SEBI at the International Organisation of Securities Commission (IOSCO). We have built up a close relationship over the years in international standard setting, and in developing the Asian capital markets. Chairman U.K. Sinha has more recently done much to raise the profile and voice of Asian regulators during his time as the Chair of IOSCO’s Asia Pacific Regional Committee (APRC).

3. I should also mention that SEBI and MAS were part of the pioneering discussions nearly 10 years ago to establish the Comprehensive Economic Cooperation Agreement (CECA) between Singapore and India.

4. Allow me therefore to add my sincere congratulations to SEBI on the milestones you have achieved for India, and for the way you have worked collaboratively with other regulators to develop Asian capital markets.

5. I believe there is still significant room for Asian capital markets to grow and complement one another, so that we diversify sources of funding for corporates and tap on the growing pool of savings in Asia itself. In particular, the Asian bond market is coming into its own. We expect significant growth in corporate bond issuance in the decade ahead, and significant growth of global and regional investor interest in Asian bonds.

The structural shifts in global finance

6. How can we take advantage of structural shifts in global finance - not just the capital flows we see today in a world growing at different speeds, but the underlying shifts in global finance? These shifts present challenges but also opportunities for us - in particular to unlock the potential for long-term finance to support economic growth in Asia.

7. First, we are seeing a long-term shift in the way in which savings are being deployed in the advanced world, with an increasing allocation going towards the emerging markets. There has always been a home-market bias in the way in which savers, including even institutional investors, decide on asset allocation in their portfolios. However, we have been seeing the gradual unwinding of this home-market bias over the last decade, and this is a trend that is very likely to continue.

8. If you look at the US for example, despite the trends of the last decade, pension funds and insurers typically have only 4% or so of their investment portfolios invested in emerging markets, well below the MSCI All-Country Index weight of about 13% for emerging markets, and of course far below the share of emerging markets in global GDP. So there is significant underinvestment in emerging market equities. Similarly for bonds. Global institutional investors remain significantly underinvested in Asian bonds and emerging bonds generally.
 
9. There is scope for this adjustment to continue for several years to come: an increasing flow of new money into the emerging markets plus also a gradual reallocation of the existing money, which is a large stock of assets, to the emerging markets.

10. A second structural trend, still among savers in the advanced economies, there is the discernible shift towards more short-term and more liquid assets. This is because they are getting older. The baby-boomers are moving into their early retirement years, and it is entirely rational for them to prefer lower risk. Their investment portfolios will become more short term, more liquid. 

11. The third structural trend has to do with savings in the emerging countries themselves. By and large the emerging world has young and growing populations, with India being a foremost example. There is hence great potential for growth of indigenous savings as well as for regional pools of savings within Asia. The wide variation in savings rates amongst the emerging countries, including those who are at a similar stage of development, in fact suggests that with the right conditions savings can increase in more economies. India today has slightly above average savings amongst the emerging countries, but even in India there is still significant scope for savings to increase.

12. Importantly, however, we have not yet seen this growth of savings in emerging countries being translated into long term finance. As in the advanced economies at an earlier stage, savings when populations are young and have a longer runway to accumulate retirement assets can be invested for the long term. But we have not yet seen a significant portion of emerging country savings flowing into longer-term, less liquid instruments. 

13. Where households invest for the long term, real estate is disproportionately favoured, across Asia. It is long term, but it is not the type of finance that feeds economic growth. India is also somewhat unique in its households’ preference for gold. 

14. Together, these three structural trends in global savings pose a challenge.   Advanced economies’ savers are channelling more of their funds to emerging markets, but increasingly also taking a shorter-term orientation, which is natural for an ageing population. Emerging markets’ savers, while they are still early in their working years and able to look forward to higher incomes over time, are able to save more and invest for the long-term.

15. We therefore need new forms of intermediation and risk mitigation, so that we can transform these two major savings pools of global savings into long term investments, to renew growth. That is the crux of the challenge, and the opportunity.

16. This is the case for the advanced nations themselves. But it is probably most critical to emerging nations because, where infrastructural development is a key strategy not just for economic growth but for equitable and inclusive societies.

17. New forms of intermediation are also necessary because of changes taking place within the global financial architecture itself. In particular, the changes that are taking place within global banking: bank lending for longer-term projects such as infrastructure is declining, and will become more expensive. This shortening of bank lending is largely a consequence of the regulatory changes in the post-financial crisis era, including Basel III, and in some cases the tightening of rules within individual countries.

18. This trend will impact the emerging economies to a greater extent because their capital markets are less developed and we have relied heavily on banks in the past to finance infrastructure projects.
 
19. But there are also opportunities in this. First, to develop the bond markets, as Indian Prime Minister Manmohan Singh just emphasised in his speech. There is great scope to develop the corporate bond market and long-dated bond markets. Second, there is the opportunity to tap on the largest pools of institutional investor money globally and in Asia - the pension funds, insurers and sovereign wealth funds - to develop long-term finance.

20. The pension funds and sovereign wealth funds (which are often backed by pension liabilities) collectively, are looking at infrastructure as part of their long-term asset allocation. Insurers too are starting to take an interest in the infrastructure debt market, in particular at the lower-risk end such as senior infrastructural debt or debt funds.

Six priorities in growing long term and infrastructure finance

21. Given the broad trends and opportunities, how do we get things moving? How do we translate savings into long term finance? I will mention six priorities that I believe we have to focus on.

Addressing policy and regulatory risk

22. First, we have to address policy and regulatory risks in infrastructure investment.  This is the key concern for long-term investors.
 
23. What are investors in infrastructure trying to achieve? They are in general not looking for excessively high returns. Typically they look for high single-digit or low double-digit returns in infrastructural investments. They are also willing to hold these investments for the long term, over 10 years.

24. What is critical is that these are long-duration investments, and the risk has to be appropriate to their ability to bear it because they are not looking for exceptionally high returns. There are ways we can achieve this, but first we have to start with providing predictability in regulation and reduce policy risk.

25. This is honestly an issue all over the world for long-term investors. It is not just an issue in emerging markets but in advanced economies, although this does not get written about as often. Advanced economies like the United States and Europe have substantial need for infrastructure investment, or re-investment in ageing infrastructure. But we have seen regulatory changes in Europe which have had retroactive effect, seriously impacting investor confidence. In the United States, there is a tremendous need to modernise the infrastructure in transport, utilities and other areas. But movement has been slow because the politics of federal and state government is in fact a much more complicated process than meets the eye.

26. We have to address this problem of policy and regulatory uncertainty not because we want to do a favour to private investors. The objective is to help public finances. Otherwise, private investors have to price in uncertainty, and they are likely to overdo it because regulatory uncertainty is difficult to price. This means either infrastructure projects cannot be done because it is too costly for the public sector, or when it is done it is at higher than necessary cost.

Credit enhancement to encourage private funding

27. The second priority is to find innovative ways in which the multilateral and regional development banks and governments can collaborate to enhance credit quality, so as to bring in private finance.

28. They have already begun playing this catalytic role. Asian Development Bank (ADB)’s partnership with the India Infrastructure Finance Company Ltd (IIFCL) is an example. Another example is the Credit Guarantee and Investment Facility (CGIF) among the ASEAN+3 countries working together with ADB.

29. We have to explore this space more actively. Resources are not plentiful at the multilateral development banks, but they can play a catalytic role for private funding by focusing on credit enhancement and risk mitigation.

30. There is also scope to segregate risk, particularly for greenfield projects where the key risks are in the initial stages of construction and development. The public sector working together with multilateral agencies and the banks can play a large role in these initial phases, with refinancing by institutional investors coming in later on where projects are operational.

Developing the securitised asset markets

31. Third, and related to this, is the opportunity to develop the market for securitised bank loans.

32. Securitised loans are a very small proportion of Asian markets -  compared to the US for instance, where it went too far before the last crisis, but where securitisation performs a healthy role in the financial system. In Asian emerging markets, securitised assets are less than 5% of the financial system. There is scope to grow.

33. We have to fine-tune regulations to facilitate securitisation of infrastructure project loans, so we get more investors into the game and allow the banks to recycle their capital. Concerns about quality have to be addressed, for example by ensuring there is still “skin-in-the-game” for the banks originating the securities.

34. There are also important regulatory issues to address with regard to bank lending in the first instance. Banks have expertise in infrastructure financing and we should not lose this expertise. We should review how bank regulation and Basle III treats ‘secure project finance’, ie where there is a guarantee from a public sector entity, so that the risk is regarded as that of the sovereign.

Governance of institutional investors to foster long term horizons

35. A fourth issue has to do with the investment horizons of institutional investors.   If we look back on what happened during the global financial crisis: although institutional investors are in principle able to have long-term horizons, in practice their collective behaviour was severely pro-cyclical. In other words, they cut back sharply on risk assets, rather than riding out the crisis and picking up value, for better returns over the longer term.

36. This is an important but complex issue, to do with regulation and governance of the funds, with accounting conventions and with systems of risk management that are generally too focused on short-term value-at-risk. But again there solutions. There are leading funds that have adopted governance and performance measurement frameworks to allow them to take the longer term view. Institutional investors constitute a huge potential pool of long term finance.  We have got to get this right to allow them to play more of a counter-cyclical role in crises rather than to accentuate the downturns through their collective actions.

37. Insurers, in this respect, require special attention. Although they have long-dated liabilities, insurers currently have a relatively small proportion of their portfolios allocated to long-term investments. There is room for regulators in both advanced and emerging economies to allow insurers to invest for the long term, without compromising the interests of those being insured. This is an important regulatory space we have to focus on. In the emerging markets, this will go hand in hand with the growth of the pool of insurance savings, for which there is still considerable scope.

Developing deeper pools of domestic savings in emerging markets

38. Fifth, we need to develop deeper pools of domestic savings in emerging economies. Prime Minister Manmohan Singh spoke about this too in his speech, including the need to translate household savings into holdings of longer term assets.&nb sp; There is critical need in emerging markets for institutional investors, who stand between households and the risks of long term investments.  

39. There are especial opportunities in developing pension funds, and in so doing to avoid the mistakes made in many of the advanced economies.  The first lesson they have given us is to avoid relying heavily on pay-as-you-go social security systems which end up with large unfunded liabilities. We should focus instead on defined-contribution, funded social security systems.  The second lesson is that the best time to institute sustainable social security is when populations are still young. Fortunately, in emerging markets like India and Southeast Asia we are still at a stage where we can put in place the foundations for sustainable social security.

40. India for example has undertaken several important measures to develop defined-contribution pension schemes, starting with public servants and subsequently for all Indian citizens including even those in the informal sector.

Finding complementarity in Asian markets

41. Sixth and finally, there are significant opportunities to develop regional capital markets concurrently with domestic markets, and to tap on cross-border finance within Asia.

42. Within Asia, there is considerable heterogeneity arising from the different stages of development of capital markets, different demographics and different savings profiles. This heterogeneity is the basis for collaboration within the region.

43. East Asia’s surplus savings can, as we develop Asia’s capital markets, be put to better use closer to home within the Asian region. It is currently disproportionately invested in western markets. This can be a win-win opportunity, both for the economies which are short of savings, as well as an opportunity for institutional investors within East Asia’s surplus economics to be able to diversify their assets and obtain the right risk-return profiles in an era where advanced country markets are expected to deliver weaker returns.

44. We know the benefits of cross-border funding for companies: being able to obtain the most competitive pricing (even after currency swaps), being able to borrow across a broader range of tenors, and being able to diversify sources of funding so as to develop greater resilience in the face of domestic and international financial shocks.

45. India made an important relaxation in its External Commercial Borrowing (ECB) rules in 2012, which has helped Indian corporates to tap offshore funds. There is strong interest among investors and funds, in Singapore in particular, to have more avenues to participate in India’s growth. In fact, several recent bond issuances by Indian banks and corporates in Singapore were heavily oversubscribed, suggesting much potential for intra-Asian funding to grow.

46. However, a deliberate and calibrated approach to opening up domestic markets up to offshore funding still remains the sensible route. Successive financial crises have taught us that a big-bang approach has more risks than benefits.
 
47. I should finally highlight the potential role of the exchanges in Asia. They can and should provide the platforms to aggregate liquidity in the region. We know liquidity is important for price discovery and for the resilience of markets. We should focus on how we can link regional pools of liquidity in different markets. In particular, exchanges with strong domestic liquidity like Mumbai and Shanghai could partner with exchanges which bring complementary international liquidity pools.

48. I believe therefore that there is significant scope for financial centres in Asia to complement one another. We must deepen both our domestic and regional capital markets to facilitate sustained economic growth. We must focus especially on developing the long-dated corporate bond market, and infrastructure finance.  There are specific ways in which we can do this, by developing the intermediaries and instruments that mitigate risks to households, and allow us to translate the significant pools of global and regional savings into funding for longer-term investments. We have an important window of opportunity in this decade to get this done.