The Hindu Business Line : RBI move has primary dealers in a cleft stick

THE world of 17 primary dealers, badly disfigured by losses, could get more careworn, if the RBI goes ahead with a proposal to "get them to commit" to bid 100 per cent at each auction of government paper.

The proposal, thrown open by RBI at a meet with primary dealers (PDs) last week, has not amused the market. Going by the Fiscal and Responsibility and Budget Management Act, the RBI cannot subscribe to government paper from April 1, 2006 leaving banks, primary dealers and insurance companies to underwrite fiscal exuberances of New Delhi and State governments. Over the last three years primary dealers did well in a regime of soft interest rates; but 2004-05 could see most of them making losses which could overflow into the current year as many believe that the 10-year paper could touch 8 per cent by around October.

Managers at PDs are unsure whether they can take the load assigned to them by the RBI. Some of the PDs are floated by banks and they may not be keen on helping them with additional capital as they have to tend to bulging loan books. The RBI note says: "Since the current system of annual bidding commitments does not guarantee that the notified amount will be sold in each auction, a system of bidding commitments for each auction is preferable. All primary dealers put together must commit to bid 100 per cent of each auction. This would ensure that the notified amount is sold at each auction. Even 100 per cent bidding commitments by PDs does not ensure that the cost of issuance is minimised or is in line with price discovery. Accordingly, PDs must be required to underwrite the entire amount of an auction. An underwriting auction will be held before the actual issuance. Each PD would have the responsibility of bidding a minimum percentage of the notified amount at the underwriting auction. The minimum amount will be so fixed as to ensure that the notified amount is underwritten. This will also ensure that the auction cut-offs are in line with market levels."

To get at its objective, the RBI has spelt out a Minimum Underwriting Commitment (MUC) for PDs. "The MUC of each PD should be designed to ensure that at least 50 per cent of an auction is covered by the aggregate of all MUCs. Thus, with 17 PDs in operation each PD would be deemed to underwrite 3 per cent of the notified amount of each auction in its MUC. The MUC will be uniform for all PDs irrespective of their capital or balance sheet size," says the note. Then comes the Additional Competitive Underwriting (ACU). "The remaining portion of the notified amount should be open to competitive underwriting. Each PD would be required to bid a minimum of 3 per cent of the notified amount.

The auction should be uniform price based. The ACU will be remunerated through commission," goes the note.

Then comes the clincher. The RBI says, "Only those PDs who succeed in the underwriting auction for a minimum of 5 per cent of the notified amount will be paid underwriting commission on their MUC. Others will get commission to the extent they are successful but will not get any commission on 3 per cent of the notified amount."

Primary dealers are sore; with no takers they will not be able to hold on to government securities in a bearish market. In recent days, banks have kept off auctions preferring loans or the reverse repos of RBI. More, PDs may not be able to financially last the experiment of bidding for 100 per cent of government auctions.

The RBI has promised exclusivity and book building as baits. Exclusivity will provide PDs lone access to government auctions with banks, corporates and insurance companies buying from them, which many say is international practice; book building will lend sophistication. In the absence of screen-based trading (hijacked by six top gilt traders), there is no way that the debt markets can discover fair prices and yields.

There were some references to introducing "when issued" and "short sell" practices when everyone knows that short selling has been banned by Parliament.

If the RBI does go ahead (it has to abide by the FRBM Act), there may not be many PDs around to help government go on a wild binge.

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