A V Rajwade: Bond and derivatives markets

WORLD MONEY

Aren't we exaggerating the difficulties in managing the repercussions of capital inflows on the monetary and exchange rate policies?

If the good news on the growth front is to be maintained, it is obvious that investment in infrastructure will need to be stepped up sharply, much of it in the private sector or in public-private partnership. This poses a major challenge to the domestic bond market, as such projects will need a much longer-term financing than currently available in the corporate bond market.

In recent years, the Reserve Bank of India (RBI) as the merchant banker for the government of India, has increased the average maturity of government bonds. Its success as a merchant banker, however, may well create some problems for the RBI in its role as the banking supervisor, through the huge mismatch in the asset-liability structure, particularly of the public sector (and old private sector) banks, in the over five-years category. (Unfortunately, despite some efforts, I am not able to get meaningful data on the point from the Report on Trend and Progress of Banking in India, 2004-05 "" in any case, over five-years needs to be split into several buckets.) The interest rate risk being taken is obviously too high. The RBI has mitigated the accounting provisions problem by increasing the HTM (hold-to-maturity) category "" but significant economic losses have been incurred on that part of the balance sheet as well.

As I started with, further demands on bond market financing are going to be made by the infrastructure sector "" and also the state governments. Some reforms would help.

One important, but relatively easy to solve, issue is that of day count conventions. These conventions are important for the quoted prices of bonds in the secondary market. And an efficient secondary market is a sine qua non of a flourishing primary market. Today, there are differences in the day count conventions in the government securities market (30/360) on the one hand, and the corporate bond and interest rate swap markets (actual/365) on the other. The 30/360 day count convention is a relic of the era when computing power was not widely and cheaply available, an era when bond prices used to be estimated from bond yield tables! Surely, with the dramatic transformation of computing power over the past couple of decades, we can easily move to the actual/ actual day count convention that would bring the conventions in all the markets much closer to each other.

The second issue pertains to the products in the swap market. Until about six months ago, there were only two liquid swaps "" the MIBOR-OIS and MIFOR swaps. Liquidity in the latter market has dried up following certain actions of the banking regulator. (In any case, MIFOR is an artificial benchmark "" there is no cash market priced at MIFOR.) To an extent, this gap has been filled by the one-year INBMK benchmark "" but even this market is not too liquid. Thus, for all practical purposes, the market today does not have a floating rate benchmark between the overnight MIBOR and the one-year G-Sec yield. Surely, something in between is needed "" in the international market, for instance, the most liquid swap is the three/six months LIBOR. Unfortunately, the term MIBOR market is still far from liquid, and cannot really serve as an acceptable benchmark. To my mind, the only available alternative at the moment is the 90/180 day T-Bill yield as the benchmark.

Such a swap would also be useful for standardising housing finance interest rates, and structuring securitisation issues "" securitisation on a large scale will become necessary to support the growth in housing finance, infrastructure loans, and help mitigate the interest rate risk on asset-liability mismatches for the commercial banks.

One question about a T-bill benchmark is that most participants would like to pay fix and receive floating. Who would be on the other side? To my mind, in the current scenario, the only possibility, apart from life insurance companies and pension funds, would be foreign institutional investors, particularly hedge funds, who are quite used to the "carry" trade of borrowing short and lending long. The question of encouraging FIIs in the debt market has come to the fore after the report of the Lahiri Committee and the RBI representative's dissent to the majority view. While I plan to comment on the issues in a later article, at this point, I would like to make two observations.

For FIIs to be freely allowed in the INR derivatives market, RBI's worries about capital flows would be redundant.

In any case, are we not making too much about the difficulties in managing the repercussions of capital inflows on the monetary and exchange rate policies? China, with a huge current account surplus and much larger capital flows than ours, has managed to keep inflation low "" and a competitive exchange rate.

avrco@vsnl.com