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Photo: Pradeep Gaur/Mint
Photo: Pradeep Gaur/Mint

Pricing sub-sovereign debt

RBI's proposal to price state govt debt at market valuation will make credit availability pricier for even fiscally sound states

There seems to be a conflict of interest in the Reserve Bank of India (RBI)’s statutory role as banker and debt manager for state governments and its position as the banking regulator. Even as it wants to adopt a market-based pricing for state government bonds, it is constrained in view of the potential losses to commercial banks holding this debt. For these banks, the biggest investors of such bonds will have to carry out a mark to market for these investments in case a market-based system is adopted.

Earlier this year, RBI proposed to scrap the existing system that allows banks to value state debt at a fixed spread of a quarter-percentage point over central government bonds. Even though it gave certainty to issuers and investors, such a system is not reflective of the issuer state government’s creditworthiness and fiscal performance.

This proposal of pricing state government debt at market-based valuations which RBI is currently contemplating is a natural step ahead of the fixed spread method. RBI’s proposal to price state government debt at market-based valuation will make credit availability pricier for states, even those ones that have a robust economy. Currently, state development loans (SDLs) to G-Sec bond spread stands at 63 basis points (bps) versus the historical average of 65 bps. The recent reduction in the spread from 90 bps to 60 bps level has been due to an increase in the 10-year G-Sec benchmark yield. One basis point is one-hundredth of a percentage point.

In 2006-07, in a major reform, RBI and the government had moved from a system of predetermined amount of state government borrowings and coupons to a full-fledged system of auction of state government securities.

The proposed move to uniform market-based pricing has experienced a hiccup. Recently, two auctions of state debt fell short of targets as investors, mainly state-owned banks, stayed away. They perceive, and rightly so, that they will be forced to book losses if their holdings are subject to market pricing. The demand for SDLs has dropped as banks have estimated mark-to-market losses of about 60 bps on their state bond portfolios if the rule is implemented as proposed.

It is to address this waning interest that RBI is now considering to adopt a uniform pricing method used for government bonds to sell state debt. This is essentially a way to mitigate some part of risk of state credit. Instead of making piecemeal changes, especially tailored to suit investors, it is better to makes these changes as a part of a comprehensive re-examination and re-organization of the sub-sovereign debt market. The sub-sovereign debt market includes any level of government below the Union government; essentially the states and municipalities that issues bonds. The sub-sovereign market in India is completely dominated by commercial banks and financial institutions such as the Life Insurance Corp. of India.

There are three factors necessitate this re-examination. First, the size of this market. In the current fiscal year, the amount of gross borrowing from the market is expected to be in excess of 6 trillion this year. The outstanding internal debt of the states constitutes nearly 75% of gross internal liabilities.

Second, are the changes in the framework of fiscal federalism, which started with the 43rd and 44th Amendment of the Constitution and have been continuing ever since. There has been a growth in the number and amount of sub-sovereign entities issuing debt. This has not been adequately recognized in the sub-national borrowing set up. Nor is the fact that there have been significant changes in the structure and function of government entities below the national or sovereign level.

In the emerging new federal setup, with operations of public services and capital infrastructure investments in roads, hospitals, bridges and other infrastructure moving to the state governments, it is important to re-examine the issue of access to capital at the state government and even municipal level. This needs a full-fledged functioning sub-sovereign bond market that will serve as an independent source of financing for state government and local governments.

Third, there is a wide difference across state governments in terms of credit rating as well as fiscal performance. This is not adequately reflected in borrowing costs. For instance, in the auction held in the last week of March, Gujarat, with an average fiscal deficit of 2.4% of gross state domestic product over the past three years, paid a yield of 9.75%, while West Bengal, with a deficit of 3.6%, paid 9.85%. Pricing state debt at market valuations will create an intra-state spread of more than 300 to 400 bps.

As such, it is important that before making these changes RBI stipulate that entities issuing sub-sovereign debt are rated by credit agencies for credit worthiness and soundness criteria. It may well turn out that some sub-sovereign bonds will be rated almost as high as the highest rated sovereign bonds.

Haseeb A. Drabu is an economist, and writes on monetary and macroeconomic matters from the perspective of policy and practice.

To read Drabu’s earlier columns, go to www.livemint.com/methodandmanner

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