The dormant Indian bond market seems to have suddenly sprung into action. Economist Ajay Shah had once wonderfully compared it to a Potemkin village, with computer screens displayed to ignorant visitors. There was very little activity behind the impressive paraphernalia of the trading rooms. Has this changed?
Look at what has happened in recent weeks. The Narendra Modi government said in the last week of December that it would need to borrow an extra Rs50,000 crore to fund the fiscal deficit because revenue was lower than expected. Bond yields shot up by 18 basis points in response.
The government went back to the drawing board. It came back a few days later with a lower target of Rs20,000 crore of extra borrowing. The bond market gave a thumbs up. Bond yields fell by 16 basis points.
It is perhaps too ambitious to say that the bond market actually managed to push back against the might of the Indian government. But there is no doubt that it made its voice heard. Meanwhile, monetary policy makers have also had to keep an eye on what the bond market was saying. The yield curve—or more specifically the difference between the repo rate and the interest rate on the benchmark 10-year sovereign bond—has steepened on expectations of higher inflation. JP Morgan economist Sajjid Chinoy wrote in this newspaper in January that this is the steepest yield curve in the past seven years, other than periods of crisis.
Just as it is too ambitious to say that bond market vigilantes forced the government to change its fiscal plan, so it is premature to claim that it has led rather than followed monetary policy. However, the recent episodes do show that the Indian bond market could be gradually coming into its own, and this is potentially a profound shift away from the financial repression that has been a hallmark of the Indian economic policy framework.
India embraced financial repression for two big reasons. First, the government needed to get access to national savings at low rates of interest because of the abandoned strategy of industrialization led by the state. Second, the growing fiscal deficits after the 1970s could be funded easily only if a large proportion of bank deposits were impounded by the government. Much has changed since then. Financial repression was institutionalized for fiscal reasons, but it had monetary implications as well. A Reserve Bank of India governor would often tell me that any country with large fiscal deficits plus financial repression could not have an effective monetary policy.
The liberalization of interest rates after the economic reforms of 1991 undermined one pillar of financial repression, though the committees headed by Sukhamoy Chakravarty and N. Vaghul had called for this in the previous decade. Most interest rates are now determined by the market, though the sheer size of the annual borrowing by the government tends to dominate the bond market.
There has been less success in undermining the second pillar of financial repression. The statutory liquidity ratio (SLR) is still too high, and this column had earlier asked (goo.gl/0iLiC7) whether active bond markets could curb fiscal profligacy: “Most of the public debt issued by the Indian government to finance the fiscal deficit is held by public sector banks. SLR is the regulatory tool through which the government has created a captive market for its bonds. So the interest rates on sovereign bonds barely react to changes in public finances. It is always worth asking whether a new fiscal law needs to be complemented by a more active bond market, which will push up borrowing costs whenever fiscal policy goes out of control."
The limitations of the Indian sovereign bond market are well known, especially the thin trading volumes. Pricing based on risk is also still a distant dream. One good indication is the pattern of yields on state government bonds. There is as yet too much convergence, which means that state governments with weak financials get to borrow at around the same rate as state governments with stronger financials. This is a bit akin to Greece borrowing at the same interest rate as Germany before the financial crisis. A greater dispersion of state government yields—or a higher standard deviation—would be a useful indication of the maturity of the Indian bond market.
Though this column is focused on the sovereign bond market, the growth in the primary market for corporate bonds also has potentially important repercussions — a financial system where large companies borrow directly from the bond market while small companies meet their financing needs through bank credit. As is the case with sovereign bonds, the secondary market for corporate bonds is also thin, with most investors holding them till maturity. And even while non-bank funding is growing in importance in terms of new flows, it is sobering to remember that the stock of commercial bank loans is six times larger than the stock of corporate bonds. It is also worth asking whether a company such as Kingfisher Airlines would have found it more difficult to keep borrowing in an alert bond market rather than from sympathetic banks.
The bond market has usually been totally overshadowed by the equities market as a gauge of the economic mood. That could be changing—if what has happened over the past weeks is any indication.
Niranjan Rajadhyaksha is executive editor of Mint.
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