Column: Rajan vs RBI

Oct 22 2013, 02:43 IST
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SummarySuccess of IRFs will depend on the Rajan factor. But the old RBI mindset that mistrusts markets may come in the way

The Reserve Bank of India (RBI) is said to be gearing up to initiate an interest rate futures market yet again. Will the product be a success, or will it fail like the previous attempts? The most important factor that favours success this time is Governor Raghuram Rajan. The most important factor that works against it is the old RBI mindset that fundamentally mistrusts markets.

Why might this time be different? In contrast to the earlier approach of micromanagement, Rajan’s view as indicated in the Raghuram Rajan report indicates that exchanges should have the freedom to design products. It says:

“Exchanges should have the freedom to structure products according to market needs. The issue of removal of ‘segments’ of exchanges becomes particularly important with interest rate derivatives.”

This time we may thus expect that RBI will change its policy of control and command and dictating the product it wants traded regardless of the market for it.

Second, in the past, a key method that has been used to prevent the emergence of a market has been to interfere with rules about participation. Certain kinds of financial firms are cut off from accessing the bond depository (which is run by RBI), or the CCIL, or currency futures trading, etc. This is a contrast with the strategy of the equity market, which is open to everyone. If a market has to get liquidity it needs all kinds of participants. For example, if there is demand from foreigners who are buying government bonds to hedge, then they will bring liquidity to the currency and interest rate futures markets and should be allowed to participate.

What is different this time? Again, the difference may lie in Rajan’s approach. The Rajan report says:

“The architecture of trading with SEBI-regulated exchanges is conducive to free entry for financial firms and free entry for participants. As an example, currency and interest rate derivatives could become immediately accessible to all financial firms and all market participants (for example, FIIs) by bringing them into the existing policy framework of SEBI-regulated exchanges.”

Third, in the past, the market design of the product has prevented ‘cash settlement’ of interest rate derivatives.

In contrast, the Rajan report says:

“Exchange-traded interest rate derivatives using both cash settlement and physical settlement should be permitted. These can trade alongside equity derivatives on NSE and BSE.”

Fourth, in the past, it was claimed that the existence of interest rate derivatives interfered with the conduct of monetary policy.

The Rajan report says:

“Monetary policy involves changes in the short-term interest rate by the central bank; the Bond-Currency-Derivatives Nexus would enable the ‘monetary policy transmission’ through which changes in the short-term policy rate reach out and influence the economy through the market process of changes in all other interest rates for government bonds and corporate bonds.”

It may, therefore, be expected that this time the development of the interest rate derivatives market will be seen as something RBI will see as a help to improving monetary policy transmission, rather than something that weakens it.

Fifth, in the past, it was believed that short-selling is bad and speculation and arbitrage is evil. A liquid interest rate futures market, and an arbitrage-free yield curve, requires the ability to borrow government bonds and sell these borrowed bonds. These were discouraged. Hedging was permitted, but you could not buy derivatives unless you held the underlyings. So only banks holding government bonds could buy interest rate derivatives. This way, the market did not get diverse positions or liquidity.

The Rajan report says:

“In a well functioning financial system, all these prices—exchange rates, interest rates for government bonds and interest rates for corporate bonds—are tightly linked through arbitrage. The key policy goal in this area lies in fully linking the markets, and for these markets to (in turn) be linked to other financial markets such as the equity market. When India achieves a well functioning BCD Nexus, this would have a number of implications. It would enable funding the fiscal deficit at a lower cost and with reduced distortions.”

There are, of course, prudential concerns about this and they are addressed by the mechanism that is being used for borrowed shares. In India, the clearing corporation becomes the legal counterparty when shares are borrowed. This eliminates counterparty credit risk. This identical mechanism can be easily used with bonds.

Sixth, in the past, policymakers have muzzled the market when they do not like what the market is saying. Of essence for the future is a more mature perspective, where the market is viewed as a aggregator of the views of the economy. When the message from the market is bad, shooting the messenger only makes it worse.

Indeed, the bond market and the currency market are powerful sources of accountability for the government. When policymakers make mistakes, which will induce bad outcomes in the future, the market makes a net present value about future outcomes and reports it as the price right now. This generates a feedback loop which gives short-sighted policymakers immediate responses when mistakes are made that will lead to damage in the long run. If we want economic policy in India to fare better, it is important to unmuzzle the Bond-Currency-Derivatives Nexus.

The Rajan report says the following about the BCD nexus:

“It would produce sound information about interest rates at various maturities and credit qualities…”

In summary, we may expect the outcome on RBI’s initiative on interest rate futures to be different if the Governor’s view prevails over the old RBI mindset in which the command and control instinct dominated. If, instead, in the old style, ways are found to restrict, stifle, manipulate, control and micro-manage the interest rate futures market are found by the staff used to dealing in the old way, this could become another failed attempt.

The author is RBI Chair Professor, National Institute of Public Finance and Policy, New Delhi

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