Ashima Goyal

Deepening India’s bond markets

ASHIMA GOYAL | Updated on March 12, 2018

Bond markets give a general fillip to infrastructure financing. — M. Govarthan

The inaction on this front is puzzling, since it would help all parties concerned – Government, corporates and households.

Bonds offer more transparent, traded alternatives to debts made in the form of traditional loans.

So, it is puzzling why, despite so many committee recommendations and regulatory focus, India has had such difficulty in deepening its bond markets.

Corporate bonds account for only about 4 per cent of the country’s GDP, compared with 70 per cent in the US or 49 per cent in South Korea. Moreover, there is hardly any secondary market, with the bulk of turnover coming from the top 5-10 traded bond issues.

Bond markets require risk-free benchmark yield instruments for pricing of credit risk. The country does today have a large Government securities (G-Secs) market for this purpose. This market has developed rapidly since 2000 and is resilient enough to absorb large orders without affecting price.

But while government borrowings are large in terms of large and regular issuances — Rs 6.7 trillion in 2011-12 — there is hardly much turnover in these.

Not only has the turnover ratio been constant around unity since 2004 but the top five G-Secs alone account for 86 per cent of total traded volumes.

Also, benchmark risk-free yields are well established only for limited tenors, especially the most traded 10-year paper. Nor is there any great diversity in the G-Sec market participants, as 70 per cent of the stock is held by banks.


Regulations in any sector evolve through democratic feedback. It requires strong leadership to bring about change unless all interested parties are on board. In the case of bond markets, the stasis is puzzling, since deeper bond markets are likely to help all parties.

Firms will gain since a healthier balance sheet is a prerequisite for issuing bonds. They, hence, impose more discipline than equity, since equity shares risk, reducing the downside. So bond issuances can be a signal of financial strength. One reason firms tend to underinsure business reversals and external shocks is a lack of adequate domestic financial instruments.

The government also benefits from deepening of bond markets, since apart from giving a general fillip to infrastructure financing, more participants and instruments enables it to borrow more cheaply as spreads reduce. Households, likewise, need more risk-free instruments that will also help revive falling financial savings in the economy: An active retail market in G-Secs and inflation-indexed bonds should have, indeed, developed long ago.

While regulators recognise that controls make for a fragile financial system — which has helped trigger the move to more market-based systems — they are also concerned about stability. A more diversified financial system is the way to ensure stability. Even open market operations by the Reserve Bank of India (RBI) can be better facilitated through active bond markets. Market interest rates discovered across different tenors and risks help in the smooth transmission of policy rates.

One way by which an active bond market could be developed in the country is through a gradual reduction in the proportion of G-Secs that banks can ‘hold to maturity’ (HTM) rather than trade them. Currently, public sector banks prefer not to trade, since if they declare a G-Sec as HTM, they need not mark its prices to the market.


The Chakravarty committee of 1984 had recommended HTM only to protect banks from large capital losses on their SLR holdings, in the event of interest rates rising with its recommended move to market rates.

Today, we are seeing two-way movement of interest rates. Yet, fears about the impact of removing HTM on bank balance sheets and on government borrowings continue to be voiced. The SLR, as the Narasimham Committee had pointed out, is meant only to satisfy a prudential requirement and not a government financing function. The new Basel III regulations will not allow it to be used for both.

RBI Executor Director V.K. Sharma recently noted how a large IRS (interest rate swaps) market has developed, which is, however, dominated by foreign banks. They account for 80 per cent of notional principal amount outstanding here, whereas the public sector banks have barely a 2 per cent market share.

The yield for five-year IRS is 100-120 basis points below the corresponding G-Sec yield, giving a huge arbitrage opportunity for public sector banks, if they hedge interest risk in this market.

That the appetite for fixed rate-receiving is large is borne out by the fact of the Rs 50 trillion IRS market exceeding the outstanding stock of Rs 30 trillion for dated G-Secs.

Therefore, banks may well gain if a gradual reduction in HTM forces them into the IRS market for hedging interest rate risks, even as it would reduce the cost of government borrowing.

Currently, banks hold about 29 per cent of their net demand and time liabilities as G-Secs, against the minimum statutory liquidity requirement (SLR) of 25 per cent, so the incentive to hold G-Secs may be too large. If banks’ balance sheets are marked to market, it will force them into more diversified assets, including SME credit. As they look for more tradable assets, corporate bonds, too, will receive a fillip.


Continuous regulatory action has sought to develop bond market infrastructure and instruments.

Two attempts to develop interest rate futures in 2003 and in 2009 failed. Initially, there was lack of liquidity as only two underlying long-term G-Secs were deliverable.

But the market size has changed now, and physical settlement allowed. Repo in corporate bonds was allowed in March 2010, followed by an expansion of eligible securities.

The applicability of credit default swaps was also expanded. Simultaneously, stock exchanges developed trading platforms for transactions in debt securities. There are now also multiple rating agencies.

But more action is required to promote the above markets, since they will further two critical current macroeconomic objectives — financing infrastructure investments and boosting domestic financial savings to reduce the current account deficit.

To expand the investor base, retail tax breaks could be given, even as a wholesale trading platform is developed. Insurance companies and pension funds could be allowed to invest in corporate bonds, on the basis of rating rather than on issuers’ category.

Reducing transaction costs can make public bond issues attractive compared with private placements, while consolidation, along with some reduction in HTM, can improve secondary market liquidity.

Although domestic investors should have the top priority, foreign investors are now increasingly willing to take currency risk in high-growth Asia by lending long-term in local currency. Such foreign savings could be tapped.

(The author is Professor of Economics, Indira Gandhi Institute of Development Research, Mumbai.

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Published on February 11, 2013
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