Jamal Mecklai: Rum, soda and deregulated markets

MARKET MANIAC

Many years ago, when I was young(er), unmarried and (more) foolish, I remember I was at the Casbah one night, by myself, drinking a few rum and sodas. Casbah was my favourite bar in Bombay at the time, on Hill Road, just opposite New Talkies Cinema""it's long gone now, of course, part of the mini-multiplex-mall-madness. But anyway, that night I was just chilling, (probably) smoking a cigarette, and looking around, when suddenly, these two African girls walked in.

That sat me up sharply. First of all, this was a long time ago, and you didn't see too many Africans wandering around Bombay. And secondly, and much, much more important, one of them was just extraordinarily beautiful. My throat ran dry and I quickly ordered another drink. She was wearing [poetic licence] a tight, printed summer dress that showed her off just right, and I knew that I just had to meet her.

I finished my drink, signalled for another and got up to find my way to the toilet. As luck would have it, I had to walk right by their table, and, as I passed them, totally unpremeditated, I said, "Excuse me, but are you girls from Switzerland?"

They looked up in surprise, and I sat down.

They didn't even smile. And then, one of them""the beautiful one""said (and it seemed it was directly to me), "Interest rates in India were kept artificially low for too long."

Huh? I couldn't believe it. Here I had all sorts of thoughts""mostly prurient""and she was talking about interest rates? And this was""probably""1986 or 87 and everybody I knew felt interest rates were much too high.

I didn't know what to say, but, it was an opening. We got to talking and it turned out they were economics students and had just come out of an exam and she was talking about the period just post-independence when rates were indeed kept low. "And," she continued, "artificially low interest rates means artificially high inflation. And while inflation affects everyone, it affects the poor more."

She smiled triumphantly, with the beginning of mischief at the edges. We had a few more drinks and I don't remember a thing after that.

But, I've never forgotten that comment.

And I recalled it again recently when I saw a news item that reported that Indian companies had borrowed over $6 billion through FCCBs in the last quarter of 2005 (as compared to $4 billion in the preceding three quarters). Clearly, with the stock market on a roll, convertibles are a cheap way to raise money.

But, I thought, why aren't people issuing domestic convertible bonds? Well, I answered myself, because there is no liquidity in the secondary corporate bond market and hence no demand in the primary market.

Now what if, I reasonably thought, there was more liquidity in the domestic bond market. Well, first off, borrowing costs would be lower""more liquidity means lower costs. How much lower would borrowing costs be? Well, it's obviously impossible to tell, but given that AAA credit spreads in India today are only around 75 basis points, while the medium-term average AAA spread in the highly liquid US market is 35-40 basis points, it is clear that there isn't too much room for borrowing costs to come down at this point. [Of course, it is likely that in a more liquid market, the government yield curve itself would be lower, but somehow that deficit-buster doesn't seem to get any points with the RBI.]

The point at hand, though, is that if there were reasonable liquidity in the domestic bond market, it would stand to reason that some part""possibly a large part""of the FCCB (and other ECB) demand would come into the domestic market, which would increase the upward pressure on interest rates. How much? Again, it's impossible to quantify, but it would seem reasonable that there would be times when rates would rise by more than the illiquidity premium (of around 40 bp today, as suggested above) and times when they would rise less.

Interest rate volatility would increase, the interest rate derivatives markets would rise from its stillborn state, banks would be better able to manage their risks, which would make them more competitive and, in a glorious virtuous cycle, enable them to bring interest rate spreads lower. Perhaps more importantly, the [by-now-college-going] daughter of my beautiful African companion will not have to bemoan how poor policy continues to keep interest rates in India artificial, which in turn keeps inflation artificial, which keeps the poor under unfair pressure.

How to increase liquidity in the corporate bond market? Well, here are some ideas for the RBI:

a) accept corporate bonds (with an appropriate haircut) for SLR and repo;

b) permit/encourage CCIL to accept corporate bonds for repos;

c) permit short selling in all bonds;

d) encourage bond market brokers;

e) assign its most senior officers to spend time in bars in Bandra.