Developing the swap market

Since independence, India has largely followed the British banking model of relying on commercial banks for credit (with a few notable exceptions). This model is well suited to serve the working capital needs of the low-end manufacturing sector—around 75% of the value of high-end manufactured goods now consists of services embedded in it: research, design, sales, advertising and so on. However, in order to serve the long-term financial needs of corporate borrowers, we need a developed corporate bond market.

The bond market in India is dominated by government securities (G-secs). Due to the large and growing borrowing needs of our government, its merchant banker, the Reserve Bank of India (RBI), probably finds it best to arrange long-term bond issuances—to manage a smaller gross issuance in a year. Banks are large investors in G-secs, at least partly because of regulatory requirements. But banks largely have short-term liabilities. So, if they invest in long-term fixed-rate G-secs at a lower interest rate and if the current short-term deposit rates are higher, either their profitability would suffer (even to the point of insolvency) or their borrowers would have to pay a disproportionately higher interest rate for making good the banks’ loss.

This problem can be avoided by an interest rate swap, a derivative that makes it possible to convert fixed interest rate cash flows into floating interest rate cash flows, or vice versa. Often, the swap market in India is dominated by foreign banks. In general, foreign banks are highly dependent on the overnight call money market for credit; this call money rate is the floating rate for the swap market. And the swap curve generated by this rate—a curve that sketches across a timeline the rate for swaps at different maturities, like a yield curve does for bonds—is often lower than the G-sec yield curve. Thus, a borrower in the overnight interbank call money market will effectively be able to borrow at a rate lower than the rate paid by the government, regardless of the credit risk.

India’s swap market thus requires a floating rate benchmark that is relevant for hedging the interest rate risk for most of its banks (public and private). For such a benchmark, we could use either the 182-day treasury bill rate or a new benchmark explicitly linked to, say, the average of RBI’s repo and reverse repo rates. Such a benchmark will make possible:

• Long-term floating interest rate government securities that do not cause huge interest rate risk for banks.

• The same benchmark may be used for loans to companies that may then use the swap market to convert them to a fixed rate as and when desired.

• Floating rate corporate bonds would have a spread over the sovereign floating rate benchmark corresponding to their creditworthiness, making it relatively easy to compare these bonds across issuers long after the issuance date. This would enable the development of the secondary market, which in turn would help form a virtuous cycle by aiding the pricing of new corporate bond issuances.

With a sovereign floating rate benchmark, RBI could even influence the shape of the sovereign yield curve quite effectively whenever desired, by just intervening in the swap market and without directly intervening in the government bond market.

With one stone, we could kill not just two birds—banks’ interest rate risk and a corporate bond market—but also target a third: RBI’s monetary policy transmission.

A.M. Godbole is an adviser with AV Rajwade and Co. Pvt. Ltd, a risk management consulting firm. These are his personal views. Comments are welcome at otherviews@livemint.com

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