Y V Reddy: Developing bond markets in emerging economies - issues and
Indian experience
Keynote address by Dr Y V Reddy, Deputy Governor of the Reserve Bank of India, at the Asian
Conference, jointly hosted by FIMMDA, PDAI, and Thai BDC at Bangkok on 11 March 2002.
Dr Reddy is thankful to Dr A. Prasad, Mrs Usha Thorat and officers of Internal Debt Management Cell of the RBI for
their assistance.
* * *
Governor Dr. Tarisa Watanagase, Dean, Yoshitomi, Dr. Nachiket Mor, Mr. Joshi & friends,
It gives me great pleasure to deliver the keynote address at the Asian Bond Conference organised
jointly by the Thai Bond Dealing Centre (Thai BDC), Fixed Income Money Market Dealers Association of
India (FIMMDA) and Primary Dealers Association of India (PDAI). It is a matter of significance that some
of the major self-regulatory organisations (SROs) in the debt markets of Asia have taken this initiative to
exchange ideas and experiences of the emerging economies from Asia and I am sure that this
Conference would be mutually beneficial as each one of us gains valuable insights by absorbing the
experience of other countries.
The importance of developing domestic bond markets to diversify risks in the financial system is being
realised since the crisis in Asia in 1997, and development of the Government Securities Market is of
course integrally linked to the development of bond markets. Worldwide, interest in the subject in the
recent past is evident from several initiatives taken. For example, the Asia Pacific Economic
Co-operation (APEC) has launched a collaborative effort on the subject. The IMF and the World Bank
are currently finalising guidelines on public debt management. The IMF is also conducting select
country studies in public debt management and India has agreed to be a case for study. The Asian
Development Bank Institute (ADBI) recently released its policy recommendations for Designing New
and Balanced Financial Market Structures in Post-crisis Asia. I am happy that Mr. Yoshitomi will share
the recommendations later this afternoon. The theme for the Deputy Governors Meeting at the Bank for
International Settlements (BIS) last December was Development of Debt Markets in Emerging
Economies. I would draw heavily from these discussions in flagging issues for consideration while the
Indian experience would illustrate the complexities in addressing some of these issues in a specific
country context.
My address today initially provides an overview of the reasons advocated for the development of a bond
market, followed by a second section giving the possible motivations for development of bond markets.
The third section explains the rationale for development of Government Securities market and the
justification for the central bank to be actively involved in it. While section four outlines the key issues
relating to the market for Government Securities, the fifth section mentions some aspects relating to the
non-Government or corporate bond market. The sixth section on select institutional issues deals with
the role of institutional investors, self-regulatory organizations, banks in bond markets, credit rating
agencies and tax regime. The concluding section makes a few observations on the road ahead for
development of debt markets in India.
1. Why develop debt market?
First, the basic philosophy of developing a diversified financial system with banks and non-banks
operating in equity markets and debt markets is that it enhances risk pooling and risk sharing
opportunities for investors and borrowers. More specifically, the case for ensuring the presence and
development of debt markets is made on several grounds. First, in the absence of a debt market, the
banking system would be larger than it otherwise would be. Prevalence of a domestic debt market can
move a crisis outside the banking system making it easier for the Government to stand back. As Alan
Greenspan has argued, coexistence of domestic bond market and banking system helps each to act as
a backstop for the other. In the past, countries like Japan have developed with almost total reliance on
bank intermediation but the risks of such excessive reliance are more in a relatively open economy
since non-bank intermediation may get located outside the country. It is also argued that domestic bond
market helps in avoiding the double mismatches of currency and maturity.
Second, it is argued that debt markets facilitate efficient financial intermediation as they use market
mechanism for allocating and pricing of credit. In particular, debt markets are expected to facilitate
availability of long-term funds for specific uses such as for infrastructure. They also infuse greater
transparency in the process of credit allocation in view of the information that is contained in market
determined rates. In fact, e-commerce makes information sharing less costly, and hence it is easier to
develop bond market infrastructure in the current environment for facilitating transparent market-based
allocation of credit. It may be difficult for Government to intervene through debt market for directed
subsidised lending as compared with the banking system. Hence, it is claimed that debt markets
facilitate the reduction of bad loans. Furthermore, since debt instruments are mostly rated, investor
awareness and monitoring is greater, which mitigates the moral hazard arising out of deposit insurance
as in the case of banks.
Third, debt market can help develop the derivatives market thereby facilitating hedging mechanisms and
enabling greater diversification of risks by participants. Also, the variety of instruments possible in the
domestic debt market may result in gains to savers and borrowers.
It is also essential to recognise that domestic debt markets may not be able to deliver in reality all that is
sought from them. The efficiency of bond markets would depend on the efficiency of credit rating
agencies (CRAs), standards of accounting, auditing and disclosures, institutional infrastructure,
prevalence of an environment for enforcement of contracts, etc. Bond markets may not necessarily
reduce systemic risk since banks themselves could be major players in bonds as issuers, investors and
underwriters. Development of a debt market for long-term instruments would also require
complementarity of policies such as flexibility in interest rates, enabling legal environment, etc. Though
higher degree of transparency is to be expected, it has been argued that where sophisticated
instruments like options exist, transparency in debt markets may not be automatically ensured.
Furthermore, a domestic bond market by itself need not necessarily address the fundamental issues of
risk management and pricing of risk.
On balance, the current realities would lead one to believe that the banking system will continue to be at
the centre of the financial system in emerging economies. In fact, banks are likely to have significant
direct or indirect presence in the debt market as issuers, investors or underwriters. If the overall
environment in the financial sector contains problems in pricing of risks by banks, bond markets too can
suffer infirmities in pricing. As the financial system is evolving, bank loans and bond contracts must be
treated as complementary and to some extent as substitutes. In view of the undeniable benefits of a
multi-institutional financial structure, a number of countries are rightly devoting considerable resources
and attention to the development of domestic bond markets, though each country may have different
motivations for doing so.
2. Motivations for development of domestic debt markets
The main provocation for undertaking the task of development of debt markets would depend to some
extent on the different histories and cultures of countries, but predominantly on economic factors such
as experience with high inflation, transition from Planning, restructuring economies after crisis, etc. More
specifically, and in the context of the financial system, the objectives may relate to financing
Government deficit, funding bank restructuring, creating a more complete financial markets, avoiding
banks from taking on excessive credit, risk diversification in the financial system, conducting monetary
policy, sterilising capital inflows, providing a range of long-term assets for pension funds, etc.
The impetus in Hong Kong for instance, seems to have come as a market development strategy
towards achieving efficient financial intermediation and making the market more complete. Similarly,
Singapore reportedly views the debt market as a means of financial intermediation to help credit
allocation, and development of corporate bond market was given high priority as an alternative funding
source in order to reduce reliance on bank intermediation.
In a restructuring economy like Hungary, the motives appear to have been different, viz., reducing the
monetisation of Government deficit, increasing competition to banks which had wide spreads between
deposits and advances and encouraging foreign investment in Government debt in domestic currency.
In the second half of the 1990s, monetary policy considerations relating to the information content of the
yield curve and concerns with the transmission mechanism of monetary policy must have added
impetus to the development of debt markets.
Recapitalisation of banks appears to have been the driving force in Indonesia. In Chile, the debt market
developed mainly as an offshoot of pension reforms. The growing pool of savings needed Government
instruments for investments, whereas the Government had a surplus. The history of over hundred years
of inflation seems to have created a demand for inflation indexed bonds.
China views Government borrowing as the most important reason for financial deepening and the
Government Securities market provides the lead in development of the bond market. Furthermore, it
would be possible to develop the corporate bond market with an efficient benchmark of Government
Securities.
In India also, large Government borrowings have provided the impetus for development of bond market.
A system of the Reserve Bank of India (RBI) funding on an automatic basis, the Government's budget
deficit at concessional rates of interest was replaced in April 1997 by a system of RBI financing the
temporary mismatches between expenditure and revenue of Government at market aligned interest
rates. Consequent to the dismantling of the administered interest rate regime, the borrowing
requirements of the Government are now largely raised from the market at market related rates. As
India experienced capital inflows and considered intervention or addition to foreign exchange reserves,
it used domestic eligible marketable bonds in its portfolio whenever it wanted to sterilize the money
expansion. A deep and liquid debt market naturally facilitates this process and in this sense the linkage
between capital inflows, sterilization and development of debt markets can also be considered to be an
additional reason for development of debt market.
3. Need for widening and deepening the Government Securities market
The relevance of Government Securities can be viewed from three points of view, namely from
Government which wants to borrow; from their role in financial markets especially debt markets and
from the operation of monetary policy. First, from the viewpoint of the Government/fiscal authorities, the
development of a deep and liquid Government Securities market facilitates public borrowings at
reasonable costs and avoidance of automatic monetisation of Government deficit by the central bank.
Broad and well-functioning secondary markets are particularly important where the Government's
borrowing needs are substantial. A well developed Government Securities market provides flexibility to
the debt management authorities to exercise various options to optimize maturity as well as interest cost
to the Government, to minimize the market impact of large or lumpy Government debt operations and,
facilitate better co-ordination between monetary policy and debt management.
Second, the Government Securities market provides the backbone of most fixed income markets across
the world since it helps pricing of various debt instruments through creation of a benchmark, enables a
proper evaluation of risk and acts a conduit for convergence of interest rates in other markets. In
addition, the gilts market acts as the channel for the integration of various segments of the domestic
financial market and help establish inter-linkages between internal and external financial markets. It is
sometimes argued that it is not always necessary to develop a Government securities market. Some
countries do not have Government Securities market because their Governments have no funding
requirements and in such countries, alternate benchmarks have developed so that price discovery has
shifted from a single Government market to a range of non-Government markets. Thus, inter bank repo
rates, collateralised obligations, interest rate swaps and top rated corporate bonds have gained
acceptance as benchmarks in such markets.
Third, a number of countries are moving away from the use of direct instruments to indirect instruments
such as repos and direct open market operations. Government Securities facilitate the development of
implementing indirect instruments of monetary policy. Typically, Treasury Bills and Government Dated
Securities are ideal instruments for conducting repos in many emerging economies. While the T-Bills
market serves the objective of raising finances for the Government, it also spurs the development of the
money market. An important ingredient in the development of money market is the terms under which
liquidity is available from the central bank. If liquidity adjustment support is available with certainty in
regard to quantity and price, it could impede the development of the money market as banks will desist
from entering into transactions with each other. In fact, the link between development of money market
and the Government Securities is an important aspect of development of debt markets.
The primary interest of the Reserve Bank of India (RBI) in financial markets is because of their criticality
in acting as the transmission channel for monetary policy especially while RBI is moving towards
reliance on indirect instruments of monetary policy. The Government Securities market is the
predominant part of the overall debt market and interest rates in this market provide benchmarks for the
system as a whole. Currently, the RBI is the monetary authority, regulator of Government securities
market, issuer and manager of Government borrowings, for both the Centre and the States, and
regulator of money markets as well as forex markets. The RBI's concern in development of the
Government Securities market should be seen in this light, while recognising that the regulation of debt
market as a whole, in the context of public issues by corporates and trading in stock exchanges where
debt is traded, is in the regulatory jurisdiction of the Securities Exchange Board of India. In India, the
RBI considers that well functioning markets for Government Securities are necessary for both effective
Government debt management and monetary management, while serving the broader interest of
development of financial markets in general and debt markets in particular. Accordingly, RBI has taken
a number of initiatives in developing both the primary and secondary markets for Government
Securities.
4. Key issues relating to the Government Securities market
There are several motivations for and objectives in a central bank being interested in developing
Government Securities market and hence the issues involved vary in significance from country to
country as also in the context of the stage of development of markets. The key issues are: relevance of
the money market, operational aspects relating to the primary market, significance of secondary
markets, policy conflicts in debt and monetary management and dilemmas in market intervention.
Relevance of development of money market
A money market supports the bond market mainly through the process of liquidity. In addition to the
importance of money market for financing positions, money market prices liquidity and anchors the short
end of the yield curve. The existence of a repo market helps the development of an active Government
vice-versa
Securities market and since lending and borrowing under a safe environment can be fostered
through repos. Where interest rates are liberalised and debt management and monetary policy functions
are with the central bank, policy coordination needs to be maintained between the Government
Securities and money markets.
In regard to the money market in India, the basic objective in recent years has been to develop a
short-term yield curve with deep liquidity. A four-fold strategy has been adopted in this regard. First, a
liquidity adjustment facility has been in operation, comprising repo and reverse repo operations through
auctions conducted with a view to equilibrating the liquidity and keeping the short-term interest rates
within an informal corridor. Second, the call money market is being developed as a pure inter-bank
market with a phased withdrawal of non-bank participants who are currently lenders in the call money
market. Third, the traditional sector-specific refinance support is being rationalized and additional
recourse to the established liquidity facilities is being made increasingly market-based. Removal of
established facilities on fixed terms and moving to a full-fledged Liquidity Adjustment Facility (LAF) is on
the active agenda. Fourth, the other money market segments, especially the repo market are being
developed with lending as well as borrowing access to the non-banks in these markets. To help the
process, a Clearing Corporation of India Ltd. (CCIL) has been established.
Operational issues relating to primary market
Ensuring efficient price discovery process is a dominant objective of operations in primary markets and
for this purpose putting in place credible systems and ensuring transparent mechanisms are critical.
Auction Technique and Central Bank Participation in Auctions
Auctions are the most common method for sale of Government Securities, though securities are also
distributed through tap sales, syndication and book building process. In many countries, direct
participation in auction is restricted to select investors while a larger investor base is permitted to enter
auctions through designated intermediaries such as banks and Primary Dealers. The actual modalities
of reaching the investor base would be governed by pragmatism and in fact even choices in auction
techniques or even combination of techniques may in some circumstances be linked to permitted
pattern of participation. As regards technique, discriminatory price auctions keep away investors
because of the winners curse, whereas there are dangers of irresponsible bidding and of collusion in a
uniform or Dutch type of auction. Countries have moved between discriminatory and uniform price
auctions, but there is no settled wisdom as to which type of auction is better. An interesting variant that
merits further consideration is a combination of the features of both auctions, i.e., discriminatory price
auction with a ceiling, in order to mitigate winners curse.
In general, central bank participation in auctions is best avoided, but if it becomes necessary, a central
bank ought to participate without competing with other bidders. There is a distinction between a central
bank buying Government Securities on its own accord and being compelled to do so. In many countries,
either there are laws prohibiting central bank participation in primary auctions such as in Indonesia and
Peru or central banks voluntarily restrict themselves from participation as in the case of Malaysia,
Philippines and Hungary.
In India, auction method has been the most favoured, though such auction could be based on yield,
price or discount, with or without some underwriting commitment of Primary Dealers at the discretion of
RBI. Both discriminatory and uniform price auction techniques are used but the former is dominant and
multiple price auction format is predominantly used for Government Securities issuances while uniform
price auction is used for 91-Day T-Bills. In the context of the need to attract retail investors, bids
received on non-competitive basis within the notified amounts are cut-off at the weighted average yields
derived in an auction.
The question of central bank participation as an outsider in primary auction does not arise in India since
the RBI itself conducts the auction. The RBI, however, used to take private placements liberally in the
past but more recently it does so only in extraordinary situations, and it has also decided to voluntarily
move out of devolvements on itself. The Fiscal Responsibility and Budget Management Bill, which is
under consideration, proposes an explicit provision that prohibits the RBI from purchasing Government
Securities in the primary market.
Instruments
Countries have experienced with different types of instruments, to suit their unique circumstances, to
broaden the markets. Hungary for instance has gradually moved away from short maturity bonds to
long-term fixed rate Government bonds enabled by the fact that it avoided hyper-inflation. Similarly,
Israel favoured the simple plain vanilla bonds although there is a presence of a variety of instruments
such as (Consumer Price Index) CPI-linked, fixed-rate and variable-rate bonds and it has progressively
lengthened maturities. Chile favours inflation-indexed bonds.
The RBI has experimented with different types of instruments such as the fixed coupon bonds, zero
coupon bonds, capital indexed bonds and more recently floating rate bonds. Most of the bonds,
however, are of the fixed coupon variety though recently Floating Rate Bond issues have proved to be
attractive.
Maturity Profile
On the maturity profile, there is no ideal solution, but trade-offs between long-term and short-term
maturities on considerations of market preference, cost to Government, bunching of maturities, and
development of yield curve should be recognised. Development of Government benchmark securities is
an essential element of a well functioning Government Securities market and this requires the issuer to
make conscious efforts to avoid fragmentation and where necessary consolidate issuance. Typically,
benchmark securities in domestic markets are 2, 3, 5 and 10 years, while countries like the USA issue
securities up to 30 years.
In India, Government revived borrowing at market rates in 1992-93, and most of the new maturities
were compressed below 10 years. This was necessary at the time as it coincided with the period of the
high interest rate cycle, and the successful implementation of the auction system in the early stages of a
move to market related rates of interest required a shortening of the maturity structure. This resulted in
bunching of maturities as well as rendering liquidity management difficult. In the last two to three years,
the RBI's preference has been towards longer maturities, at fixed rates to bring about a balance in the
maturity structure. There would be times when Government is reluctant to lock in what it perceives to be
high rates, and the banks face larger asset liability mismatches and greater interest rate risk.
Recognising this, the RBI has reintroduced floating rate bonds and is attempting to develop the STRIPS
market in the Government Securities segment. As regards consolidation, RBI has extensively used the
technique of re-openings of existing securities on the basis of price-based auction. Thus, advantage
was taken of large gross borrowing programme to lengthen the maturity profile and consolidate the
profile.
Issuance Calendar
Based on first principles, it is better to provide a clear and timely information about the borrowing
programme through an issuance calendar, in addition to maturity profile of outstanding stock,
redemption calendar, etc. In operational terms, issuance of a calendar has to tackle the trade-off
between certainty to the market and flexibility to the issuer in terms of market timing.
The uncertain trends in terms of cash flow pattern of the Government of India constrains the publication
of issuance calendar. In respect of T-Bills, a pre-announced issuance calendar for auctions has been
evolved. Recognising that a large market borrowing programme and uncertainties in cash flows make
issuance of full-fledged calendar somewhat difficult at this stage, the Finance Minister announced in the
budget speech recently, that there will be a calendar of auctions of Government from the financial year
beginning April 2002.
Role of Primary Dealers
Many countries have established a system of licensed Primary Dealers (PDs) in Government Securities
as important intermediaries to promote activity in Government Securities market. Typically, PDs are
assigned specific responsibilities like minimum bidding requirements, giving two-way quotes, providing
market information to the central bank, etc. In some cases, PDs have been given exclusive right to
primary auctions, or some special facilities in money market operations, open market operations,
underwriting commission, etc. PDs can play a vital role in the development of the secondary market. By
being in the market, their prices discount all available information, they take up trading positions, and
also render valuable assistance to the central bank by providing it with latest market information,
designing new instruments, etc. Since PDs are generally highly leveraged, regulatory oversight over
PDs appears to be warranted and a common feature among central banks has been to periodically
review the performance of PDs and make the continuation of their operations performance-based. An
interesting feature that merits notice is a rating of PDs as established in Poland.
The institution of PDs has been adopted in India in 1996 for developing both primary and secondary
markets in Government Securities. The main objectives of promoting the institutional mechanism of PDs
are to strengthen institutional infrastructure in the Government Securities market in order to make it
vibrant, liquid and broad based and to ensure development of underwriting and market making
capabilities for Government Securities outside the RBI so that the latter could gradually shed these
functions. In other words, the marketisation of Government borrowings and vacation of RBI from primary
market in an environment of large borrowing programme were facilitated by a conscious development of
the institution of PDs. PDs obligations include giving annual bidding commitment, underwriting the
primary issuance and offering two-way quotes. In return, the PDs are extended liquidity support by the
RBI and access to call money market as borrowers and lenders.
Incidentally, RBI experimented with a system of Satellite Dealers (SDs) from 1996 to serve as a second
tier to PDs in the Government Securities market with the particular objective of promoting retail
segment. However, on a review it was found to be not as useful as was expected and is being given up.
Gilt Mutual Funds
Mutual funds dedicated almost exclusively to investments in Government Securities called Gilt Mutual
Funds were established in India in April 1996. Currently, there are 13 such mutual funds in the country.
Mutual funds are regulated by the Securities and Exchange Board of India (SEBI). In tune with the
developments that have taken place in the debt markets since 1996, the scheme of Gilt Funds is
currently being reviewed by the RBI. Given the small size of the repo market during that period and the
consequent uncertainty regarding availability of liquidity from the market, Gilt Funds were given limited
liquidity support by the RBI. Considering that the liquidity support was introduced as an extraordinary
measure and the fact that the repo market has developed and is expected to become more liquid with
the operationalisation of the CCIL, there is a case for reviewing the liquidity support to Gilt Funds from
RBI.
Significance of secondary markets
A diversified investor base with varied demand, maturity profile and risk preference is admittedly
important for ensuring high liquidity and stable demand in the market. Apart from banks, PDs and
mutual funds, retail investors and foreign investors can also play a role in widening the investor base.
Catering to the needs of retail investors is often an essential part of the overall strategy to develop a
more diversified investor base. Retail investment can also contribute to stable demand for Government
Securities and can provide a cushion for the impact on volatility.
Development of repo markets, short selling, the role of benchmarks and marked to market valuation,
etc., do contribute to boosting of secondary market liquidity. The practice of short selling securities
facilitated by securities lending and borrowing has been prohibited in some emerging markets and it is
necessary to recognise the rationale for this. No doubt, the ability to sell short has a positive effect by
increasing the market liquidity and price efficiency since it enables participants with differing views on
the market to trade actively, but short sales, have the potential to increase market volatility and risks
especially if the market assumes larger position than what it is capable of handling.
As regards benchmarks, many countries have been taking efforts towards consolidation and creation of
benchmarks and the procedures depend on the composition and stock of existing debt and how much
debt is proposed to be raised. Another issue relates to whether a move to marked-to-market for
investments raises any risks in terms of stop-loss sale, etc. While marked-to-market serves to
encourage secondary market trading, it is necessary to have a liquid market to correctly price securities.
The RBI has taken a number of measures to enhance the secondary market liquidity in the Government
Securities market. These include permitting a diversified participant base, improved fungibility of bonds
through reopenings, stabilizing money market through Liquidity Adjustment Facility (LAF), developing
the repo market, encouraging the operationalisation of the Clearing Corporation of India Ltd., initiating a
negotiated dealing system for trading, enforcing marked-to-market requirement for valuation of
investments, ensuring a Delivery Vs Payment system for settlement of Government Securities in
scripless form, and disseminating detailed information to the public on a daily basis in respect of all
Government Securities traded in the market.
In India, initially the RBI was announcing the yield curve to the market for year-end valuation. Currently,
FIMMDA, a self-regulatory organisation, announces the yield curve, the methodology of which was
approved by the RBI. Incidentally, although the statutory liquidity ratio (SLR) for the banking system is
25 per cent, banks are voluntarily holding 37 per cent of their liabilities in Government Securities.
Recognising the risks involved in such large exposures, the Reserve Bank of India (RBI) has created a
path for banks to reach a targeted investment fluctuation reserve over a period.
Policy conflicts in debt and monetary management
Irrespective of whether the debt management function is vested with the central bank or not,
coordination is important to avoid conflicts between cash and debt management of the Government and
central bank operations. The timing and amounts of Government Securities issuance may not always
coincide with the compulsions of the central bank's monetary policy. The Government may wish to issue
securities at a time when the market is illiquid and the central bank needs to consider whether or not
and to what extent it will provide additional liquidity. Liquidity can be provided through the secondary
market or where the central bank is both the debt and monetary manager, it has the option to operate
through the primary market.
Currently, almost all central banks are harmoniously co-ordinating with the fisc, both at the policy and
operational levels with regard to debt management. There is general agreement that being the fiscal
agent creates problems for central bank and separation of debt management function from the central
bank would remove the friction. In a situation of high fiscal deficit and lack of fiscal assurances on its
responsibility, separation of the two functions could increase the ri