Once again, the petroleum minister Murli Deora has requested the finance minister to issue oil bonds. In what is becoming common practice now, the money thus raised is going to be used to “compensate the firms for selling below cost”.
For starters, this move is simply bad financial practice, for it violates one of the basic principles of corporate finance – that the cash flows of the source of funds should approximately match the cash flows of the application of funds. it is quite an extreme case of violation here – with long term bonds being used to finance immediate expenses.
Leaving theory aside, while this measure, at the moment, may solve the cash flow problems, there is much doubt about the future. By issuing bonds, the firms are simply taking on more debt, which has to be repaid some day. What these bonds are doing is to just postpone the losses, and also, in a way, amortize them over several years.
Now, it is easy to see that issuing oil bonds is akin to taking on a personal loan. It is just like a loan to spend on a wedding, or to go on a holiday – or any other loan which is used to fund an expense, and not an investment. And if you have been to a bank and cared to look at their different products, you will notice that interest rates for personal loans are significantly higher than those for say home loans or car loans, which cover investments rather than expenses.
In context of this analogy, it would be interesting to compare the coupon offered by these oil bonds to the coupon offered by bonds which have been issued in order to fund investments. While business sense says that the coupon for oil bonds be much higher, I’m not sure if it is going to be the case in practice (I don’t have the figures. If you do, please leave a comment).
Now, in case we had functional corporate bond markets in India, they would have ensured that these oil bonds traded below par (assuming the coupon is similar to that for debt raised for investment) in order to account for the fact that they cover an expense and not an investment. However, the absence of such markets and government control over a large part of the financial sector enable the oil firms to get away with a low coupon.
Government owned financial institutions such as PSU banks (beautifully referred to as “SOBs” or “state owned banks” by Percy Mistry), LIC, UTI, etc. will be forced to subscribe to these issues. By subscribing at a price above the “fair market value”, these SOBs, LIC, etc. are forced to bear part of the burden arising from selling petroleum below cost.
To stretch things a little, a part of every rupee you save on account of lower fuel prices will be extracted from you by the SOBs (lower interest rates for deposits, higher rates for loans), LIC (a higher premium), etc. (the rest will go from the taxes you pay). What is effectively happening is that a part of the burden of petroleum subsidies is being redistributed, to users of public sector financial institutions and also to the taxpayers.
And as if all this was not enough, repeated usage of oil bonds would result in degradation of credit-worthiness of the oil firms, which would force them to increase the coupon rate for further debt issues, thus increasing their cost of capital, which could create much more trouble in the future.
To sum up, it seems like the issue of oil bonds will create a much bigger mess than the one it is supposed to solve. It might be useful for the government to look at alternate ways of handling this situation. Of course, it must be mentioned that the mess is not immediate – it will show up a few years down the line when the government would have probably changed. Who cares about such long-term mess-ups?