Foreign institutional investment must be increased in government debt in a phased manner, said a working group constituted by the Reserve Bank of India (RBI). The group was set up to suggest ways to increase liquidity in the government bond market and interest rate derivatives.
“FIIs (foreign institutional investors), being global players, can provide much-needed diversity of views in the market and, providing more opportunities for trading. Thus, the group feels there is a need to encourage FIIs as an investor class in the government securities market,” the group, headed by RBI Executive Director R Gandhi, stated in the report.
However, uncertainty and volatility in foreign investments have added to concern on capital flows.
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And, foreign institutional investment in government debt is capped at $20 billion. Of this, $10 billion is reserved for investment in securities with residual maturities of at least three years.
“Considering the possible effects of a sudden exit of investors on capital flow and market volatility, the investment limit for FIIs in government securities may be increased in gradual steps,” the group recommended.
The increase in the investment limit may be reviewed every year, considering the country’s overall external debt position, the current account deficit and the government’s market borrowing programme, the report added.
It also recommended doing away with withholding tax, saying this was a major hurdle to the participation of FIIs in the government debt market.
It added the mandate to surrender unused investment limits hit the ability of FIIs to actively manage their portfolios. It proposed FIIs be allowed to trade directly, instead of through exchange brokers.
The government is slated to borrow Rs 5.69 lakh crore this financial year, compared with Rs 5.1 lakh crore last year. So far, RBI has auctioned Rs 2.64 lakh crore of long-dated papers. About 65 per cent, or Rs 3.7 lakh crore, of the total market borrowing is scheduled during the first half of the year.
HTM limits to be cut gradually
The working group also proposed the upper limit of government securities held-to-maturity (HTM) by banks be reduced in a gradual manner. According to current norms, banks can hold up to 25 per cent of their total investment in the HTM portfolio. The ceiling may be exceeded only if the excess holdings are securities approved under statutory liquidity ratio norms.
The group added the limits need to be reviewed in light of the implementation of International Financial Reporting Standards (IFRS) 9. Also, banks should review the HTM portfolio to assess the need, the rationale and the cost benefits and their preparedness for effectively dealing with the proposed transition to IFRS.
Boosting retail participation
Banks and post offices may be used as distribution channels for retail participation in government bonds, the group suggested, adding the government could issue inflation-indexed bonds for individual investors.
Interest rate derivatives
The group also proposed cash settlement and revision in the contract size of 10-year interest rate futures, introduction of futures based on the overnight call borrowing rate and review of risk limits for derivative exposures.
