Mr. Reddy considers the future of India's debt market 1997 Inaugural address given
by the Deputy Governor of the Reserve Bank of India, Dr. Y.V. Reddy, at the Invest India Conferences
in Mumbai, on 9/10/97.
The Future of India's Debt Market 1997
I am happy to be amongst you this morning. This conference gives me an opportunity to
sharpen my thoughts, and gain insights from the deliberations. The subject has gained importance over
the years, and in particular, more recently after the Monetary and Credit Policy of April 1997. In fact,
there is a sudden spurt in conferences on this subject, as for example, the SBICAP Debt Market Seminar
held last month. Also, there was pretty elaborate coverage of this subject during the last two days in the
discussions of Bank Economists' Conference on the Second Phase of Reforms in the Financial Sector.
The objective of this national conference, as I understand, is to assess recent changes and
examine issues which merit urgent consideration in order to achieve an efficient and vibrant debt market.
In the seminar organised by the SBICAP, Governor, Dr. C. Rangarajan had flagged some specific issues
which would help in formulating an agenda for further reforms in the debt markets. I would urge this
audience to give serious consideration to these issues.
2. Let me, therefore, begin by highlighting the reforms initiated by the Reserve Bank of
India and the Government of India in the debt market in the recent period. These include:
• setting up of a comprehensive system of primary dealers,
• adoption of DVP system for settlement of government securities transactions,
• abolition of tax deduction at source on government securities,
• permitting FIIs to invest in debt instruments including government stock and allowing them to
hedge their foreign currency risk in the forward market,
• introduction of Treasury bills of varying maturities, and
• placing investments of banks in preference shares/debentures/bonds of corporates outside
the five per cent limit.
In a bid to increase transparency in operations, the Reserve Bank of India (RBI) has been
disseminating information on its transactions in gilts and publishing the calendar of auctions in respect of
Treasury bills and repos.
Soon, the RBI proposes to publish data on banks' investments in corporate and PSU debt
in the Weekly Statistical Supplement to the RBI Bulletin.
To foster inter-institutional coordination, a Technical Advisory Committee for
government securities and a Standing Committee on Money Market have been set up. Major issues
confronting the debt and money markets are discussed in these committees. These committees have been
found to be useful to all participants.
3. As I observe, the discussions in this conference are structured around five sessions, viz.,
primary market, secondary market, legal issues, risk management and future directions. For the sake of
convenience, I will follow broadly the same structure and pose issues for further deliberations.
Primary Market
4. Lack of market clearing yields at primary auctions of government debt is often being
cited as a significant factor slowing the development of the secondary market. The arguments run as
follows:
First, it hampers efforts to broaden the investor base.
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Second, at times when cut-off yields in the primary market are lower than prevailing
secondary market yields, it curbs secondary trading.
Third, to the extent the cut-off yields are lower than secondary market yields, it
constrains inventory build-up by primary dealers. Finally, to the extent volumes of pick-up in primary
auctions are reduced due to interest rate considerations, it reduces the availability of floating stock in the
secondary market.
5. What are the factors that inhibit market clearing mechanisms? There are four important
issues, viz., notifying auction size, type of auction, element of non-competitive bids and frequency of
auctions of Treasury bills. Another issue of concern relates to large private placements of corporate debt.
6. At present, there is no pre-announced notified amount in 364-day and 14-day auctions.
This procedure enables the RBI to determine either the cut-off price or the amounts to be accepted in a
flexible manner. Notifying amounts in auctions will bring more transparency in the auction procedure by
removing the uncertainty about volumes in auctions. In this context, it needs to be emphasised that the
capacity of primary dealers to absorb auction supply as an underwriter is limited. Currently, primary
dealers underwrite to the extent of 50 per cent of the amounts in auctions with notified amounts. In this
scenario, there is a danger of devolvement on the RBI, if there is a pre-announced notified amount. The
extent of the devolvement on the RBI can be minimised by increasing the underwriting amounts to
primary dealers. The RBI could also change the notified amounts between each auction, depending on
prevailing market conditions, in order to minimise the devolvement risk on itself.
7. Presently, there are six primary dealers. The institution of primary dealers has partly
contributed to a significant increase in secondary market transactions in government securities.
Authorising primary dealers is an on-going process. All eligible applicants will be considered by the RBI
for primary dealership. While on this subject, an issue that needs to be considered relates to the
when-issued market. At present, the Securities Contracts (Regulation) Act, 1956 prohibits short-selling
of securities. Two options could be considered. First, whether to give exclusive access of primary
auctions to primary dealers and simultaneously permit them to engage in short sales of government
securities. Second, whether to continue with the existing system of access to primary auctions and allow
all participants to engage in short sales of government securities. The timing and sequencing of this
reform -- whether to introduce it now or wait until the number of primary dealers has enlarged -- are
aspects that need to be carefully considered. I would urge upon the participants to discuss the pros and
cons of these options and the international practices in this regard.
8. There is some debate over the type of auction that is most suitable for selling Treasury
bills and dated government securities in India. There are advocates for both the discriminatory and
uniform price auctions. But, international practices seem to be in favour of discriminatory price auctions.
In a switch-over from one auction system to another, a number of considerations arise such as easy entry,
cost to issuer, return to investor, role of primary dealers, incentive to gather information, etc. This is
another area fit for a careful assessment.
9. As you are aware, non-competitive bids are allowed in 91- and 14-day Treasury bills
auctions. A major issue relates to the treatment of non-competitive bids. Country practices show that
non-competitive bidders are made allocations within the notified amount. However, the non-competitive
bidders in other countries consist essentially of small, retail and inexperienced investors. Since the
maximum bid is restricted to a small value, the competitive bid prices do not get distorted. There is a
view in the Indian market that non-competitive bidders should also be allowed as competitive bidders.
However, in our country, since State Governments are major non-competitive bidders, their volatile
surplus funds position could make their participation in Treasury bills auctions very uncertain. Thus,
there could be large swings in terms of volumes in auctions. Another view is to make allocation for
non-competitive bidders outside the notified amount.
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10. There is a view in the market that the high frequency of auctions recently brought about
by introducing 14-day Treasury bills auctions (along with frequent repos) tends to hinder secondary
market activities by reducing investor participation in the secondary market in favour of waiting for a few
days for primary issues. Also, the staggered settlement dates for Treasury bills falling on different days in
the week make secondary market trading across different maturities of Treasury bills less efficient.
Perhaps, it would be useful for this conference to discuss the need, if any, to reduce auction frequency
and adjust settlement dates of different maturity Treasury bills to fall on the same day in the week so as
to improve fungibility and thereby price discovery and market efficiency.
11. Finally, an increasingly important concern relates to the issuance of PSU bonds and
corporate debentures through private placements. Although, the private placement market plays a crucial
role in enabling corporates to raise resources, certain vital issues need to be considered for a well-directed
and efficient functioning of the market. At present, there is no transparency in this market and virtually
little information. In developed markets, the regulatory authorities indicate the framework within which
the private placement has to function, like number of persons per placement, arrangements with only
qualified investors and strict regulations to access certain qualified investors. We have to assess the
adequacy of the regulatory framework to protect the interest of investors from risks associated with
subscriptions in the private placement market. With a proper regulatory framework and more
transparency, the private placement market can develop further as an integral and important constituent
of the primary market for the raising of resources by corporates; hence, the need to deliberate on the
status of regulatory framework.
Secondary Market
12. As part of the reform process, a number of technical impediments that prevented more
active secondary market trading in government securities and Treasury bills have been progressively
removed. Let me briefly recall these:
• abolition of the system of TDS,
• issuance of benchmark securities, and
• operationalising the DVP system at all centres.
The RBI is encouraging banks to open SGL II accounts for constituents, thereby
enlarging the coverage of book-entry holding of government securities. Recently, the National Stock
Exchange has been authorised to open a SGL II account and a current account with the RBI. A decision
has been taken to extend a similar facility to the Stock Holding Corporation of India. These steps would
further streamline transfer and settlement procedures in the government securities market.
13. In respect of PSU bonds and corporate debentures, which are held mostly in scrip form,
a proper settlement system is yet to be put in place. The National Securities Depository Limited (NSDL)
was expected to dematerialise a sizeable stock of non-government debt. But, at present, NSDL has been
able to dematerialise only those securities which are exempt from stamp duty. Suitable amendments to
the stamp duty regime appear, therefore, necessary to avoid transaction costs and enable active use of the
facility. An appropriate solution is needed, since an efficient transfer and settlement system in the PSU
bonds and corporate debt segments could usher in the resumption of repos in these instruments. Once it
is assured that risk-free and transparent payment and settlement systems are put in place through a
depository like NSDL in dematerialised form, it should be possible to permit such repos.
14. Another issue that has been raised frequently relates to giving permission to financial
institutions to borrow through repos in eligible securities. While there is a risk of generating
asset-liability mismatches among non-bank participants, the conference could discuss the operational
feasibility of allowing such participants into the repo market under suitable safeguards.
15. The Reserve Bank of India is considering a range of options to increase the interest of
individual investors in government securities. There is an inherent potential for households to diversify
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their investment portfolio encompassing government securities. It would be useful to quickly review
marketing and distribution strategies adopted in other countries for reaching government securities to
households. Australia, Ireland, the Netherlands and Sweden adopt direct sales of government securities to
the retail sector through special registration facilities. Hungary, Switzerland, the UK and the USA retail
through non-competitive bidding arrangements. France and Norway use the primary dealers network.
Germany, Spain and Turkey have retailing arrangements through the banking system, while Denmark,
Ireland, and Poland retail government securities through the stock exchanges. Italy uses both the banking
and stock exchange network. The conference could do well to consider strategic options for this
important phase of market development.
Legal Issues
16. The most important segment of the debt market being government securities, let me start
with the relevant law on this. The law relating to government securities and their management by the
Reserve Bank of India is the Public Debt Act, 1944. The present act dates to pre-independence days,
when marketable debt comprised almost the entire borrowing by the Government. This is no longer
valid, with almost over Rs.300,000 crore worth of other liabilities of the Government comprising, inter
alia, instruments like NSS, Indira Vikas Patra, etc., falling outside the purview of this Act. Further,
provisions of the Public Debt Act relate to issue, servicing and repayment of government securities and
do not provide regulation of trading/marketing of government securities. For instance, under the present
Act, the Reserve Bank has no substantive powers to design and introduce an instrument of transfer suited
to the computer environment. There are other constraints, such as those which preclude the RBI from
issuing government securities in the form of promissory notes in the name of trusts, non-availability of
nomination facility in respect of government securities, barring a minor from holding government
securities, etc. A new Act on government securities is proposed to take care of these issues. Any
suggestions on this reform are welcome.
17. It seems appropriate to consider extending the use of depositories established under the
Depositories Act to government securities. The Depositories Act came into force in 1996 providing for a
legal framework for holding of equities, bonds, debentures, units and other market instruments in
dematerialised form in a depository. Such deposits come under the regulatory framework of SEBI. Since
the RBI manages the public debt of central and state governments, Public Debt Offices (PDOs) of the
RBI are in effect depositories under the Public Debt Act. Thus, giving permission to depositories to hold
government securities in dematerialised form would make the provisions of the Depositories Act
applicable to the Reserve Bank as an issuer, bringing into focus the respective regulatory roles of the
Reserve Bank and SEBI in government securities. One of the suggestions to resolve this is by way of
incorporating a provision in the proposed Government Securities Act, excluding the provisions of
Depositories Act being applicable to government securities.
18. It would certainly be useful to survey the international experience in this regard. In
Canada, Germany and Switzerland, there is central government prudential regulation of depository
institutions and provincial or state supervision of securities trading. The Bank of England used to provide
regulation of depository institutions, although after the passage of the Bank of England Bill,
responsibility for banking supervision will be transferred to the new and strengthened Securities and
Investments Board (SIB). The SIB will also take direct responsibility for the regulatory regime covered
by the Financial Services Act. In Australia and New Zealand, the central banks provide prudential
regulation of depository institutions, but there is no specific regulation of the government securities
market. The Japanese Ministry of Finance and the Danish Supervisory Authority for Financial Affairs
provide centralised regulation of government securities. As you will have observed, international
experience is varied.
19. Another legal issue which is often alluded to relates to forward contracts. This forum
would do well to discuss the advantages and disadvantages of the repeal of the government notification
issued in l969 prohibiting forward contracts in securities.
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Risk Management
20. Investors in debt instruments face three major components of risk, viz., credit risk,
interest rate risk and foreign currency risk. In case of government bonds, credit risk is zero. The foreign
currency risk is relevant only to non-resident investors like FIIs who are investing in debt instruments.
Recently, the 100 per cent debt funds dedicated to the debt market were allowed to take forward cover to
enable them to hedge their exchange rate risk. Investments in all debt instruments are exposed to interest
rate risk. This risk can be better hedged if a futures market in interest rate exists, or if short-selling in
securities is allowed. However, the futures market will be meaningful only in an environment of totally
deregulated interest rates and the existence of a term money market which itself is dependent on a
credible yield curve. Thus, while the eventual introduction of interest rate futures and permission for
short-selling is inevitable, the real issue is one of the timing of these reforms, so that it does not entail
any systemic risks.
Future Direction
21. Consistent with the spirit of financial sector reforms, the RBI is in the process of the
divestment of part of its shareholding of DFHI and STCI, so that the RBI does not have the majority of
shareholding. As you are aware, the RBI has taken the initiative to promote STCI and DFHI. The RBI is
now a minority shareholder in DFHI and, after the second round of disinvestment in l995, its share is
only l0.5 per cent. It has also been decided to disinvest shares of STCI so that after the first phase of
disinvestment, the RBI's shareholding will be less than fifty per cent.
22. Second, non-banking financial companies are now required to maintain a higher level of
liquid assets in the form of government securities and government-guaranteed bonds. This will increase
the demand for government paper in the market. This will be in addition to the demand generated due to
the opening up of provident funds to debt market instruments, emergence of MMMFs and investments
by l00 per cent FII debt funds.
23. Third, I would like to flag the vital issue of the role of market participants. Standard
practices have to be evolved by the market with regard to the manner of quotes, the conclusion of deals,
the manner of pricing and accounting standards. A code of best practices also has to be evolved for repo
transactions in eligible securities. In the context of moving towards a liberalised and market-oriented
environment in the financial sector, it would be desirable if such standard practices were evolved and
accepted in a common forum of a self-regulatory body. At present, I understand that there are moves to
create such self-regulatory body/bodies among the PDs and among banks and financial institutions
covering transactions in money and fixed-income securities markets. This is a welcome trend and the
RBI would be willing to nurture such developments in the market.
24. Finally, the time has come to accord priority for establishing electronic links between
the Deposit Accounts Department and Public Accounts Department/Public Debt Office of the RBI for
achieving synchronisation of funds and securities transfers. We should also begin planning electronic
links between banks, primary dealers and others who have access to the system, so as to pave the way for
a more information-efficient and transparent securities market. These plans can succeed only with the
concerted efforts of all -- the Government, the Reserve Bank of India and the market participants. I would
appreciate your detailed suggestions.