Hardly any variation in pricing of State development loans: RBI

In the near-absence of inter-State variations in the market pricing of State development loans (SDLs) at primary auctions, there is little market incentive for States to improve their fiscal position and lower their debt, says a new study by the Reserve Bank of India.

Bonds or dated securities issued by State governments are called State development loans (SDLs).

These are issued through auctions similar to those conducted by the Central government for issue of dated securities. Interest is serviced at half-yearly intervals and the principal is repaid on the maturity date.

The spreads on SDLs, that come in the form of market bond issuances, measure the premia of States’ loans over Central government securities and could be affected by: SDLs being sub-sovereign securities; lack of liquidity in the secondary market for SDLs; and differing fiscal parameters of State governments.

According to RBI’s Mint Street Memo (MSM), careful assessment might have to be undertaken of various explicit or implicit guarantees and regulatory treatment of SDLs if it is deemed necessary to induce differentiation in inter-State spreads.

Fresh issue preferred

Apart from prevalence of buy and hold investors for SDLs, the MSM said most States have till recently preferred to issue fresh papers, thereby failing to create security-wise trading volume even as the quantity of the outstanding remains significant.

Consequently, State securities are not actively traded and hence attract high illiquidity discount.

“We document that although the spreads of SDLs relative to the Central government securities caused by such illiquidity and prevailing market conditions are evident, inter-State variations in spreads are hardly observed in the market pricing of SDLs in the primary auctions.

“This presents little market incentives for State governments to improve their fiscal and debt positions,” said RBI’s Seema Saggar (Director), Madhusudan Adki (Assistant Adviser) and Rahul T (Research Officer) in the MSM.

Underscoring that there is no significant impact of fiscal performance variables on the spreads, the MSM said the finding suggests that market is not pricing the fiscal fundamentals of States into calculations of SDL premia.

“In contrast, the auction-level yield spreads were mostly explained by differences in the size of the notified (issue) amount announced for an auction — larger the overall notified amount, wider being the spread.

“Large States that tend to have higher borrowing needs in view of their economic size, generally place higher quantum of their paper on sale in fortnightly auctions. Together, they could push up the overall issue size and thereby the yields,” said the MSM.

UDAY impact

Surprisingly, according to the RBI officials, the impact of UDAY (Ujwal Discom Assurance Yojna ) bonds’ supply on spreads was not found to be significant.

This could be due to the fact that major parts of these bond issuances were timed when the supply of Central government bonds had stopped and the volume of SDL issuances had also tapered. As such, it helped to balance the overall supply.

“On analysing the auction data during the two years when UDAY bonds were issued, we observe that increase in aggregate SDL issue size and the anticipation of UDAY bond supply contributed more in widening the weighted average spreads of SDLs than the actual issuance of UDAY bonds,” the RBI paper said.

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