| Recent events suggest that interest rates on housing and other loans have become a sensitive subject. This makes it a good time to look at some issues in the long-term debt market, which need to be addressed if investment and growth are not to be hampered. These include the pattern of bond issues by the largest borrower of them all, namely the government of India; housing loans; and some practices and benchmarks in the interest rate swap market. |
| Government bond issues In recent years, there has been a deliberate effort to lengthen the maturity of government bonds, but, most issues continue to be at fixed rates of interest. The banking system (which is by far the largest investor), having experienced interest rate risk first hand during the last couple of years, is not keen to buy long-term, fixed rate bonds. In theory, life insurance companies and provident funds are a market but such investors still represent a relatively small proportion. |
| As the RBI is reviewing the instruments and options used, one change that could be seriously considered is the issuance of floating rate bonds in far larger proportions than hitherto. First, floating rate bonds eliminate interest rate risk for banks and would be found attractive by them. Secondly, they would also lead to a better match between the government's revenue and interest payments. This is because government revenues are broadly linked to the nominal GDP""in other words, they increase with inflation, exactly as the floating interest rates would. Therefore, the government has an internal hedge between its revenue and expenditure with floating rate bonds. They could also reduce government expenditure, first when inflation falls further to international levels, and secondly because, in any case, short-term rates to which the floating rate would be linked are generally lower than long-term yields. |
| The central bank is also reportedly concerned about the falling liquidity in the secondary market. One way of mitigating the situation is to bring down drastically the number of outstanding bonds, through swaps. Since this would be a one-time event, surely it should be possible to give a special tax consideration for the gains on bonds to be sold. Some outmoded market practices, day count conventions in the secondary market, for example, also need to be changed to improve efficiency. |
| Housing loans The rise in interest rates and the stricter regulatory prescription on housing finance have led to a rise in the cost of new and, in many cases, existing loans as well. |
| At one time when money was plentiful and there was intense competition amongst banks for lending money to home buyers, the rates had gone to unsustainably low levels. While some increase was therefore inevitable, it should also not be forgotten that an increase in the availability of housing is a socio-economic need; besides, growth in housing also impacts the demand for other goods and services, and therefore GDP growth. |
| Clearly, the present woes of the housing loan borrower would have been avoided, had (s)he opted for fixed rate loans. On the other hand, banks are reluctant to offer fixed rates because of asset-liability mismatches, given the long-term tenor of housing loans. Via medias have also been adopted in the form of semi-fixed loans, where the rate is subject to change after a specified period. Again, the experience of many borrowers is that they find it difficult to switch from one type of interest rate to the other, and that the interest rates and their variability are less than transparent. |
| One possible solution to the asset-liability mismatch problem is greater securitisation of housing loans, with the securities being sold to long-term investors like insurance companies, provident and pension funds, and indeed individuals. For a vibrant market to come into being, however, it will be useful if the housing finance lenders agree on a single benchmark for pricing floating rate debt. Each lender would be free to charge a premium over the benchmark, depending on the funds cost and credit risks involved. But, for the amateur borrower, for whom, very often, the purchase of a house and its financing are the single-largest financial decisions in his life, the rates would be readily comparable. Inasmuch as the PLR is bank-specific, the benchmark will need to be something else""in the present state of the money and banking markets, the only suitable benchmark I can think of is the 182-day T-bill yield. This would mean that the applicable rate is refixed every six months. Such a benchmark would mitigate the interest rate risk for the lenders. If, simultaneously, an interest rate swap market based on the T-bill benchmark can be developed, a point I revert to later, this would facilitate easy switching between fixed and floating rates. |
| Another reform that could be thought of is to adjust, as a matter of course, the debt-servicing changes arising from changes in interest rates, in the repayment period, and not in the EMI. There does not seem to be any uniformity of practice on this issue. Industry-wide uniform practices on such issues would also help and facilitate securitisation of housing debt. |
| Derivatives market At present, the only really liquid benchmark in the interest rate derivatives market is the MIBOR overnight index swap""the floating rate keeps changing every day. What would be of much better use in pricing loans is a 3/6-month benchmark. The ideal would be the inter-bank term MIBOR, but the market is ill-liquid. To my mind, the only other possible benchmark is the T-bill yield, particularly if the same benchmark can be used also for pricing housing loans, as argued earlier. While the T-bill may not be an ideal benchmark, we need to accept that, in real life, most things can only be done imperfectly, and that we should avoid the temptation of allowing the best to become the enemy of the good. The larger issue of floating rate bonds by the government would also facilitate the establishment of such a swap market. (There is another major anomaly in the rupee interest rate swap market""the MIBOR OIS swap rates consistently rule below G-Sec yields.) |
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