The Hindu Business Line : Market risk warrants mainly floating, short-dated gilts

Although the central bank has, for some time now, been following the auction route to sell G-Secs, there have been several occasions when they devolved, that is, the RBI was forced to pick them up entirely or in part because of undersubscription or unacceptable bids from the market, that is, low prices (or, the same thing, high yields).

This is supposed to stop from April 2006 and means that, willy-nilly, the market must fully absorb all issues. A big change indeed from the times when the RBI was on autopilot as far as funding Government was concerned. Apart from meeting devolvements, it also provided other facilities such as ways and means advances and subscribed to ad-hoc Treasury bills whenever the Government needed funds.

Will the new system fly? There are several institution-strengthening, building and strategic measures which seem to be necessary for a smooth transition.

First, the RBI must decide the role of primary dealers (PDs) and if they will have exclusivity. In contrast to the US, our PDs have the obligation to underwrite new issues of G-Secs, but no monopoly in bidding.

The central bank did not perhaps want to risk its auctions entirely on these fledgling entities and, therefore, allowed banks and other financial intermediaries too to bid directly.

Fortunately for all, the move to market-oriented gilt pricing occurred in a period of a prolonged fall in interest rates. PDs and banks vied one another to get their hands on new issues which they could turn around and sell immediately for a profit.

But times have changed. The rate cycle has reversed direction and for the past year yields have only been going up. Successful bidders in auctions have, more often than not, watched helplessly as yields shot up after an auction leaving them with losses on their inventories. Some PDs want to close shop, having taken a hit not only on new issues but also in their proprietary trading.

This has alarmed the RBI so much that it is now considering a proposal to allow PDs to merge with banks. The rationale is that the banks are far better capitalised to absorb losses and also have the flexibility to dump unwanted securities in the held to maturity inventory basket, which does not attract mark-to-market valuation and accounting rules.

This may mean extinction of PDs as we know them for although there is talk of Chinese walls between the PD activities of a bank and its treasury, policing and enforcing separation will be difficult.

The bottomline is that our bond market is still too narrow and illiquid and ill-equipped in terms of risk management instruments to absorb fixed coupon long-dated and very long-dated securities (of the type that the Government of India and RBI seem to prefer to issue) without significant potential damage to the balance sheets of financial institutions.

Till such time that the market matures, it would be better for the RBI to focus on floating rate debt and short- and medium-dated bonds for the Government's funding programme.

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