Why India could be the next big distressed market play

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But Singh’s government must hold steady on the road to reform.

India’s politicians and bureaucrats often get knocked for their dithering and inability to make clear-cut decisions. So it’s only fair to praise them when they get something right. In recent weeks, the government has made three announcements that could have huge implications for India’s distressed debt market.

The big news is that foreign investors will be able to buy Indian banks’ and financial institutions’ bad debt. The moves could also help develop a junk bond market.

Specifically, the government will now allow foreign investment in asset reconstruction companies (Arcs). These are India’s equivalent of China’s asset management companies created to help dispose of Chinese banks’ bad debt.

The way they work is as follows. An Arc issues the bank with a security receipt when it buys its bad debts. These receipts are considered as an investment on a bank’s balance sheet, and their value depends on the pricing of bad loans. The bank only gets money when it cashes in its security receipts. The amount it receives, though, depends on how successful the Arc is in recovering money from the debtor. Arcs can also take control of a company if they manage 75% of its bad debt. This is something banks aren’t allowed to do. So far, only one Arc, the Asset Reconstruction Company of India Ltd (Arcil), is operational. Another is expected to begin business soon.

No one is certain how big India’s bad debt problem is, though one banker estimates the total to be $60 billion to $70 billion. What is clear is that India has the third highest level of non-performing loans in Asia, after Japan and China. The government has realized it has to act fast to resolve the issue if it wants the economy to maintain high growth rates. Encouraging foreign investors to participate and profit from the process is a good start.

The other two measures – letting foreign portfolio investors buy receipts from the Arcs and promoting the development of a secondary market in distressed debt – are also steps in the right direction.

Certain caveats remain. The biggest question mark concerns whether India’s financial institutions have properly marked to market their portfolios. One potential investor, for example, says he has no idea whether they have or not.

Another possible bone of contention is the fact that, although the law now permits 49% foreign direct investment in the equity capital of an Arc, no single foreign investor is allowed more than a 10% stake.

Limiting the power foreign investors will have could prove to be a big stumbling block. And more reform will be needed if India’s junk bond market is really to take off. Let’s hope the government tackles these shortcomings. Otherwise the good work it has done so far could be wasted.