The Hindu Business Line : Debt market reform is the key

In the context of the emerging situation in the financial market with serious implications for the stability of the macro-economic situation, the RBI needs to put through wide-ranging reforms in the debt market. This will mean looking at some aspects of the economic policy, as also the contradictions in the tax and the administered interest rate regime and addressing them, says HASEEB A. DRABU

THE RBI needs to do some policy re-building. — Paul Noronha

In the post-reform economic regime, monetary policy interventions are the only instruments available to the government to address short-term aberrations and medium-term problems in the system. No longer can monetary policy initiatives be seen "pushing the string". The fact of the matter is that all other policy instruments have either been abolished (for example, administered interest rates) or are bound in their flexibility (for instance, public expenditure policy and deficits) by the process of economic reforms.

As such, there is a case to use the current illiquid state of one segment of the financial market as the trigger to initiate a wide-ranging reform in the debt market. This will also entail looking at some aspects of the economic policy regime. When we do so, it turns out that there are contradictions in the tax and the administered interest rate regime that is causing the problem and needs to be addressed.

NO LIQUIDITY CRUNCH

At the macro-economic level there is no evidence of a liquidity crunch, let alone a crisis. Yet there is a serious distortion of available liquidity across segments of the financial market. Just look at the boom in the stock market. Every public offer in the last year has been oversubscribed. Assets under management with mutual funds are up 50 per cent. Evidently, retail and other investors are favouring equities and real-estate over fixed-income options such as bonds or bank deposits.

Given the 74 per cent return of the Bombay Stock Exchange Sensex in the year to March 2006 and the 120 per cent appreciation in the net asset values of top mutual fund schemes, this trend is hardly surprising. The problem of liquidity, therefore, is confined to one segment of the money market — the debt segment. Even here, the problem is more acute in the corporate bond market or, more generically, the non-SLR securities market.

In such a situation, pushing in more liquidity into the system through a cut in the cash reserve ratio or other means is certainly not the answer. The additional liquidity will only flow to those segments of the financial and non-financial markets which have been soaking it in over the past few months; be it the equity or the real-estate market. Any generic solution of increasing liquidity in the system will, if anything, compound the specific problem in the debt market in absolute as well as relative terms. Also, it will have an inflationary angle.

REDIRECTING LIQUIDITY

In such a situation, logically speaking, there seem to be two possible courses of action: First, is a measure or a series of measures that will channel flow of liquidity on a sustainable basis into the much-starved secondary market for corporate debt with or without a change in the overall liquidity position. There is no such instrument available with the Reserve Bank of India.

Second, is to make the corporate bond market attractive on a relative basis vis-à-vis the government securities market. This could redirect some liquidity into the illiquid corporate bond market.

Though it is possible for the RBI to do so, either through direct or indirect interventions in the government bond market, it may not yield results in the present situation of rising interest rates. Also, there is hardly any degree of substitution between the two classes of bonds.

A rather extreme variation on this theme can be the bold step of reducing the SLR (statutory liquidity ratio) in a staggered manner. This will alter the relative price-yield equation in the SLR and the non-SLR markets and make the latter more liquid. As things stand, this will necessitate a change in the Banking Regulation Act; a blip in the liquidity conditions can hardly be justification enough for such a step.

However, this move needs to be seen in the context of initiating a long overdue comprehensive reform in the debt market. The RBI needs to see it as a first step with the long-term objective of developing a market for private debt instruments in the context of the on-going economic reforms.

The justification for doing it at this juncture is the emerging situation in the financial market has serious implications for the stability of the macro-economic situation.

SYSTEMIC RISK

Going beyond the secondary market, debt and equity markets cannot move in such a divergent manner as they are at the moment. This can cause systemic risk. Although there is some flexibility in the composition of debt-equity in financing corporate growth, too much variation in it is not desirable from the point of view of both the lenders and the borrower. If the financial sector is unable to provide funds in more or less the same proportion as required by norms, the investing entities could meet their funds need in whatever form they are available; and thereby expose them selves to needless risk. As a consequence, the overall risk profile of the economy would go up.

An active secondary market can exist only when there are a range of investors with different needs, motivations, time horizons and, most important, expectations. The debt market reform has to work within this framework. As of now, the significant players in the debt market are banks, pension and mutual funds, and insurers. Foreign funds, which enjoy considerable access to the equity market, are heavily restricted in the debt market. These funds together can hold at a given time no more than $2 billion in Indian debt. This severely constrains liquidity.

Institutional investors are too seasoned to be carried away by a stock market boom. They will want to diversify the assets in their portfolio. Hence, given the opportunity, they will want to hold a portion of their portfolio in corporate and government debt.

The restriction in the number of players has skewed the pricing in the debt market. Top-rated corporate bonds trade at spreads of 100-120 basis points over government debt yields. Many sell at discounts, which is a tragedy given that the shares of these issuers are justifiably robust. Investors are forced to avoid the debt market because of lack of liquidity, and not because there are no plays there.

TWO PRESCRIPTIONS

Two changes come instantly to mind — increase the FII limit and allow retail participation. The depth and width of the bond market needs to be increased so that investors can invest in debt securities for capital gains rather than simply hold them to maturity as income instruments. But this requires more than a mere change of policy. There are a whole lot of structural problems with the debt market that need to be addressed to change it from a wholesale market to one with some play for the retail investor. Some of these are endogenous — thin volumes with large denominations, high bid/ask spreads — and some exogenous — principally taxations on transactions and interest on competing financial instruments, such as small savings. It is unlikely that a small investor will be attracted to the bond market so long as the rate on small savings is administered. A complete overhaul of the small-savings schemes is, therefore, a prerequisite. Similarly, the secondary market retail debt transactions must be exempt from any form of central and state taxation. Or, should be at par with equity market transactions. With the kind of spreads available, most debt transactions when taxed become unviable for any market-maker.

Along with players, the number of products, especially the risk management products, has to be increased. Investors must hedge the interest rate risk through a set of well-structured derivative products geared for a rising interest rate scenario. A set of swaps and futures was introduced, but the market has floundered. There is also a need to increase investor faith in corporate debt investments.

For this, swaps and derivatives need to be introduced. For example, credit default swaps can be structured to alleviate corporate default risk. Similarly, an innovative contract, the Counterparty Risk Protection Security (CRIPS) has been suggested and can be used to alleviate risk.

Finally, to some extent, liquidity can be improved by moving to an efficient settlement system such as rolling settlements in the debt market along the lines of the equity market.

(The author is Chairman and CEO, Jammu & Kashmir Bank, and Financial Advisor to the J&K government.)

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