A V Rajwade: Issues in money and debt markets

WORLD MONEY

Even though bond yields have more or less stabilised after the scare of last year, players are jittery.

As we wait for the monetary and credit policy statement, it is a good time to review some of the current issues in the money, debt and derivatives markets.

For one thing, bond yields seem to have more or less stabilised after the scare of last year. But players are jittery and one has seen several forecasts that yields could go up sharply by the end of the current year.

The joker in the pack is the Rs 29,000-crore state government issues, to which a reference was made in the Budget speech. It remains to be seen at what premium to the Central government securities will such issues be bought.

It is also less than logical in this day and age that all the state governments' bonds should be sought to be priced at similar yields when there are major differences in their finances.

One key problem in the Central government securities market is that secondary market volumes have come down after the Reserve Bank allowed a larger proportion of the holdings to be kept in the held-to-maturity (HTM) category.

It is interesting that as against a stock of Rs 9,00,000 crore of government of India (GoI) securities, spread over 100 issues, barely a score of securities managed to register secondary market volumes in excess of Rs 250 crore in February.

It is, perhaps, time to consolidate the large number of issues into a much smaller number through swaps. The technical issues are not difficult to solve "" the holders would benefit by replacing illiquid paper with fewer number of liquid securities.

To my mind, there is also a strong case for larger recourse to floating rate paper. Floating rate securities mitigate interest rate risks for both the issuer and the holder.

Given that a large proportion of the holdings are with commercial banks "" whose liabilities are relatively short term "" it clearly makes sense for them, from an asset-liability management angle, to invest in floating rate bonds.

This also make sense for the issuer whose revenues are in many ways linked to the nominal GDP and, therefore, to inflation rates. In years of higher inflation, the floating rate would be higher "" but so would the revenues of GoI, much of which come from ad valorem customs and excise duties.

The pricing of floating rate bonds, however, does need to be rationalised. In the case of the 10-odd outstanding GoI issues of floating rate bonds, the coupons are bench-marked to the 364 day T-bill rate "" with spreads ranging from .05 below T-bill to 0.5 above it.

Surely, market prices should reflect the variation in spreads, which they do not seem to, at present.

If the investor base is to broaden, introduction of STRIPS (Separate Trading of Interest and Principal Securities) would be useful. One technical problem is that there are at least three zero coupon yield curves (ZCYCs) prevalent in the market.

A uniform methodology acceptable to the market "" say the Nelson Siegel Svensson model based on the broadest sample "" would perhaps be necessary before STRIPS succeed: to be sure, each bond player has his own favourite methodology to develop the ZCYC, incidentally one of the most researched topics in bond markets, and uses it to discover under- and over-pricing.

Coming to the derivatives market, the volumes have kept growing: the notional principal of outstanding contracts was as high as Rs 6,00,000 crore in mid-2004.

In his Budget speech, the finance minister has also announced his intention to strengthen the legal framework underlying derivatives contracts.

Recently, RBI has also come out with disclosure norms on derivatives activity. Both these initiatives are necessary and useful. To my mind, what is needed further are actions and decisions by the regulator and others involved, in the following areas:

The introduction of a netting and settlement system for swaps, which is being developed by the Clearing Corporation of India Ltd, and use of net outstandings for the capital charge;

Unified regulation by the Central bank of INR and FX derivatives. These two are presently handled in different departments of RBI and the regulatory norms are not always uniform;

An accounting standard for derivatives;

A review of regulatory restrictions on futures trading by commercial banks. In theory, the market was initiated almost two years ago but has been dead for some time now. Unless banks can trade in the market, as distinct from using it merely for hedging, it will not take off.

As for the last point, the problem is that trading in the futures contract would, in effect, permit banks to "short" a bond. This has been banned since the securities scam that happened 13 years ago.

I see little difference between a bank taking a five-year fixed rate deposit, which is freely permitted, and shorting a five-year fixed rate bond, which is banned. The credit and interest rate risks to the bank and the counterparty are identical!

Another anomaly is that the swap rate has sometimes ruled below the G-Sec yield, surely a major pricing inefficiency given the credit standing and capital charge differences between the counterparties "" Central government in one case and a bank in the other.

Tailpiece: One is saddened at the self-congratulations about the Americans offering F16s to Pakistan and a more advanced version to us.

Surely, both countries have far more pressing demands on their resources, schools, roads and water supply for instance, than competing to fill up the coffers of US arms suppliers?

avrco@vsnl.com