Reforming Government Securities Markets in India – A pre-requisite for developing active derivatives markets on interest rates

1. Government Debt Securities are “public goods:”

Economists have long recognized the special role of Government Debt (and the market where it trades) in the economy of a country. The role of National debt in economic growth has been the focus of Modigliani (1961), Diamond (1960), and Barro (1974), and more recently by Campbell and Shiller (1996), among others. Barro (1974) has argued that if the government has monopoly power in the production of bond “liquidity services,” then public debt issue has the potential to raise economy’s net wealth. In the context of debt markets, Government Securities Markets can be viewed as public goods in the following sense:

1. The presence of an actively traded “yield curve” in the Government Securities Markets provides a “price discovery” function about the risk-free cost of borrowing at different maturity sectors. This naturally provides a floor for the borrowing costs of other private institutions and agents in the economy. A corporate issuer, planning a 10-year bond issue can use the 10-year Government bond yield as a benchmark to estimate the cost of borrowing at that term. The corporate borrower now can focus on credit spreads in the issuance decision.
2. The Government is in a unique position to supply “long-term risk-free” debt unlike any other private market participant: this is due to the fact that, in any country, Government alone has the ability to issue the local currency bond that is free from explicit default risk. It is of course, possible to appropriate wealth from creditors by allowing inflation rate to go well above the expected rates of inflation, which prevailed in the market at the time the Government issued the bond. For most countries this is not a credible policy as they need to access the bond markets repeatedly. This suggests that long-term issuances of both nominal and indexed Government debt securities may in fact be a monopolistic provision of liquidity services, in a similar spirit to the arguments of Barro (1974).
3. They can serve as “sleeping policeman” to enforce discipline on monetary and fiscal policies on a “state contingent basis” the following sense:

• • A large supply of long-term inflation –linked bonds enforce a commitment to pursue monetary policies that are not inflationary. There is no better way to credibly communicate to the investors in the Government Securities Markets that the Government is serious about maintaining low inflation rates in the long run, than to make sure that a significant percentage of the outstanding Government Securities are long-term indexed securities. There are natural investors for such securities. In the United Kingdom, Pension funds are big investors in indexed-linked Gilts as they use these securities to dedicate their cash flows to meet the vested indexed obligations of retirees. Many countries have actively traded indexed Government Securities Markets, and it is unfortunate that India has chosen not to open this market. It is my view that this market, if properly structured, has the potential to lower the cost of Indian Government Debt.
  • An active and liquid secondary bond market on nominal and indexed Government Securities can warn effectively the government about the costs of fiscal indiscipline and flagrant borrowing. We have seen recently that countries with significant current account deficits have faced escalating costs of borrowing in the bond markets. The plight of Spain, Italy and other Southern European countries suggest that the power of bond investors can have a disciplining effect on deficit spending in the long run. This kind of discipline is lacking in India, where the Government is able to place its debt with a small set of financial institutions, with which it has a significant policy clout. To have a secondary market that truly signals the values across the yield curve, captive institutions holding government debt and on a “buy and hold” basis must release their inventories to other private parties. Currently, this is not happening.

2. How to Improve the Markets for Government Debt Securities:

1. Auctions, Benchmarks, and Vintages: Government must make a credible commitment to conduct regular and predictable auction cycles with defined benchmarks, across the maturity spectrum. The goal should be to develop (and sustain over time) at strategic point along the yield curve, deep and liquid benchmarks. Right now, Indian Government Securities Markets is too fragmented, with many illiquid issues, and very few actively traded issues in isolated points on the yield curve. This issue is not difficult to solve, but does require an enlightened thinking on the part of Ministry of Finance, RBI and institutions in the private sector. For example, it is important to consolidate old vintages through repackaging and buy-backs. Private sector can repackage if the markets are transparent and legal roadblocks to securitization are removed. Second, Government must make a commitment to be an active and predictable issuer in some strategic benchmark maturity sectors: two-years, five-years, ten-years, twenty-years, and thirty-years. This is central to the price discovery function.
2. Broadening Institutional Ownership: It is a stunning fact that 85% of the Government securities in India is in the hands of three classes of institutions – commercial banks, Life Insurance Company (LIC), and the Reserve Bank of India (RBI). This type of an arrangement is insidious and promotes opacity, and sets wrong incentives. In contrast, the Treasury debt issued by the United States is invested by many private sector institutions such as pension funds, mutual funds, insurance companies, banks, foreign institutions, etc. The ability of the Government to raise large amounts of debt capital (which is sorely needed in India for many infra-structure projects) critically depends on how liquid and transparent the underlying Government Securities Markets is. In addition to this very narrow ownership of Government Securities, which resemble a “private placement” market, the captive holders (such as banks in India) of Government Securities are given dispensations such as Hold to Maturity (HTM) accounting provisions, whereby the securities are held at par value, irrespective of their market prices (which in itself is difficult to get at as there is no liquid secondary market at all maturities). HTM provisions that banks enjoy serve to understate the true risk that banks present to the Indian economy. It makes the bond markets more opaque, and adversely affects the ability of the Indian Government make large scale bond issues. Banks which tend to hold Government Securities may also have less of an incentive to lend to private sector and this hinders the efficiency of the most critical credit channel in the economy. It is also in the self-interest of the Government to eventually have all Government Securities trade in secondary markets to establish a “market determined” cost of borrowing at different terms. A useful counterfactual is the following: if a significant fraction of Government Securities that is held by banks is to be eventually sold to private parties at market prices over time, what would be the yields at which they would trade? What would be the effect on capitalization of banks? Basel III and other guidelines will eventually force all countries to get their book in order, and it behooves India to think ahead and act to avoid a potentially major crisis.
3. Establishing a Retail Investor Base: It is ironic that in India where National ID can be used to deliver cash to poor households directly by the Government, we do not have the ability for saving households to electronically invest in Government securities in a “user friendly” manner. While such facilities may exist in principle, I gather that they are not a very important segment of the investor base. It is worthy of note that many households invest in bank debt instruments with a (possibly incorrect) view that such securities are default-free. The introduction of a significant retail investor base such as saving households for the Government Securities through web-based investing in small denominations will enable the Government to directly access the savings in the economy, and simultaneously put banks on notice to look for alternative sources of funding and/or be more competitive in attracting retail term deposits. Stock Exchanges can play a role in promoting Government Securities to the retail investor base. They already have a significant amount of expertise in delivering stocks to retail investors through electronic networks. They are therefore ideally situated to deliver Government Securities to retail investors as well. Significant issues, such as taxation of income from Government Securities, custody, clearing and other issues have to be addressed to make this happen.
4. Ability to finance long and short positions: institutions should be able to express their bullish or bearish views on interest rates at different points across the yield curve, in order to promote price discovery. In developed markets such as the United States and Europe, this is accomplished through markets for repurchase (repo) and reverse repurchase (reverse repo) agreements, backed by clearing arrangements, schedule of haircuts or margins for different eligible collateral. While much progress has been made recently in this area, it is nevertheless the case that liquidity is lacking for reasons cited earlier. The development of an active market for repo and reverse repo transactions with appropriate safeguards is an essential step to invigorate the cash market for Government Securities in India.

3. Spill-Over Effects of an Active Government Securities Market:

Indian Corporate Bond markets will be a significant beneficiary, if an active and transparent Government Securities Markets were to develop in India. For Indian firms, this will provide an opportunity to tap debt capital directly from investors at a much bigger scale. Additional reforms in the following areas would be important to secure a thriving corporate bond market:

• Post-trade transparency, whereby investors are in a position to see recently completed trades in the market, the size, the initiator of the trade, and the trade time. In the United States, TRACE has provided such a transparency enabling a more active participation of retail investors in corporate bond markets.
• Bankruptcy reforms, to ensure that the process of financial distress resolution in efficient. Hart (1999) has suggested three metrics for an “efficient bankruptcy code”: first, the code must be ex-post efficient, ensuring that the residual value available to all claimants is maximized. Second, the code must set the right incentives so that the creditor’s rights are protected ex-ante. This calls for severe punishments to borrowers who do not comply with their contractual obligations to the creditors. Third, some residual value must be set aside for the borrowers so that they do not take excessive risks when the firm approaches the bankruptcy state. The extent of delays and dead-weight losses associated with the distress resolution process will clearly be a key determinant, ex ante, of the attractiveness of corporate bond to the investors.

Interest rate swaps and futures markets will be the other significant beneficiaries of an actively traded Government Securities Markets. The current anomalous relationship between swap rates and Government Security yields is in, large measure, due to the issues that have been highlighted in my article earlier.

4. References

– John Y. Campbell and Robert J. Shiller, (1996) “A Scorecard for Indexed Government Debt’” NBER Macroeconomics Annual 1996, Volume 11, Editors: Ben S. Bernanke and Julio J. Rotemberg, Editors, MIT Press.
– Robert Barro, (1974) “Are Government Bonds Net Wealth?”, Journal of Political Economy, 1974, vol. 82, no. 6.
– Peter Diamond, (1965), “National Debt in a Neo-Classical Growth Model,” American Economic Review, vol. 60, 1126-1150.