R Ravimohan: Bond: dead bond

The saga of the imposition of transaction tax on bond trading is a wake up call for all those who are interested in the bond market. While the adverse impact of imposing the transaction tax has already been felt and represented, and is perhaps being resolved, what is utterly amazing is that this sad episode ever even came to pass.

For a market that is used to total transaction costs in the region of 0.01-0.02 per cent, the imposition of a transaction tax of 0.15 per cent is a death knell. Thankfully, the markets have already reacted sharply and there is reasonable hope that the transaction tax on bond trades may be dropped.

But that does not solve the problem. Knowing that the country is being led by people who are so well versed with financial markets, it is really important to understand why this episode came to pass. There are important lessons that this incident has for all those to whom bond market matters.

Before we get into the whys of the problem, it is also important to recognise the issue at hand in its totality. Not only would the cost of transaction kill the bond market trading volumes, but this tax would have serious consequences on a whole set of market structures and processes.

To begin with, the entire system of primary dealers underwriting and redistributing the bond sales of the government borrowing programme would have to be restructured. Nobody would pay the transaction tax twice.

The market, RBI and the government would have to think of a market structure that would be more compatible with the higher transaction cost system.

Of course the larger issue is that the market itself could become unviable with the incidence of any further cost. Then the issue of bond market players comes to fore.

The whole system is now transiting towards holding more securitised paper, for many good reasons. First, holding a healthy proportion of assets in a transactable form, and thereby increasing the liquidity of those assets, is an imperative in a volatile interest rate environment.

Most astute bankers are therefore already emphasising this trend. In fact the spurt in securitisation transactions in recent years is a good indicator of this phenomenon.

The Basel II capital adequacy framework also indicates that in a risk-based supervisory regime, securitised assets would come to the fore, as they enhance regulators' and players' manoeuvrability.

Structurally the markets are now adjusting to a low interest rate paradigm, which is beginning to induce changes in savings patterns. Even from the savers' perspective, a greater allocation to markets is inevitable as deposits will increasingly lose their attractiveness.

A good proportion of these funds, either directly or through mutual funds, gets allocated to the bond market. The proposed transaction tax will greatly discourage this healthy-but-incipient trend.

Lastly, but most importantly, the transaction tax will make bonds less attractive to trade and therefore make them more illiquid and therefore push up the premium and make borrowing more expensive for all borrowers. The most seriously impacted in this regard would be the government, the country's largest borrower!

So why would the government want to jeopardise so many aspects of this important component of our financial system through the imposition of the turnover tax? Either they did not know the implications, or they did not care. Both these suggestions are preposterous.

There is simply no way this leadership could be ignorant of these implications; nor would it shirk its responsibility to the financial system. Then what is the answer? Incredible though it may sound, I think they simply forgot that bonds were also securities. I think the notion of capturing short-term trades for the transaction tax was conceived with only equity in mind.

Both the concept of such a tax and the quantum of 0.15 per cent clearly suggest that it was designed with the equity markets in mind, where an additional 0.15 per cent to the existing level of close to 1 per cent was perhaps in the realm of acceptability. Amazingly, therefore, I am concluding that everybody simply forgot that bonds were also part of the definition of securities.

Actually there are several pointers to the generally low level of awareness of the concept that bond markets are included in the realm of capital markets, that bonds are part of the definition of securities and that bond markets and equity markets are completely different with little in common.

Some prominent leaders in the past have said things to the effect that they do not lose sleep over the Sensex, or that they worry more about Khan Market than the stock market! We have stock exchanges and not securities exchanges.

We have equity research and not bond research. Organisations, including regulators, concentrate more on the equity market than on bond market. One clear pointer is that the set of regulations governing the equity markets is far weightier and more developed than its counterpart for the bond markets.

Indeed in some of these organisations, we have primary market and secondary market sections and committees and not bond market and equity market divisions. The Securities Contracts (Regulation) Act, which governs the stock markets, does allude to bonds being included as securities.

But such a reminder is followed more in obscurity than in real practice, as this episode of introduction of uniform transaction tax on all securities has established.

A bond market is an important component of any financial system. The more the financial system is developed, the more importance bond markets acquire. Especially in a country like India, where government seriously depends on market borrowings for its sustenance, it is crucial that bond markets are recognised as a vital ingredient of the nation's financial system.

Lastly from a development perspective, our country is seriously under-invested, whether in terms of infrastructure, housing, agriculture or indeed manufacturing capacity. Bond markets have to be thriving to produce resources to enable the massive investments that are going to be required over the next several years.

Therefore bond markets have to be nurtured and kept centre stage in any policy design, and should certainly not be simply an appendage to equity markets. Those of us who are involved in the bond markets have to wake up to this rude reality that we have failed to elevate this market in the national conscience especially of the policy makers. We have simply been out of sight, out of bond!

Let us take a clue from Nasscom, the industry body for the IT sector. They have done a fantastic job of bringing awareness of the existence of that industry, its issues and challenges. Its achievements are not only within the country, but also in many markets around the world. We need a similar effort.

Whether it is FIMMDA or other industry bodies that are already operating, there is a need to collectively build a franchise for the bond market. The mission has to be to create bond identity! The bond community needs to bond closer to make this market centre stage.