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Vivek Mohindra
Some aspects of the Indian money markets are well rated even by international standards. The Government of India (GOI) issues treasury bills (T-Bills) across all tenors (14-, 91- & 364-day) and the yield curve is well established. T-Bills are important for the local money markets. With the establishment of the Primary Dealer network and a reduction in the Reserve Bank of India's (RBI's) underwriting role, T-Bill yields are now market determined. While the cut-off yield at the RBI auction is still considered the benchmark yield, there is an increasing amount of secondary market trading also. As a proportion of the total secondary market turnover of $16 billion in GOI securities in the first quarter of FY2000, it is small at only around 3 per cent.
Unfortunately, money markets as a whole are not developed. There continues to be structural lacunae, the primary one being the lack of development of a term money market and the consequent dependence on the overnight call market. Bankers use the overnightinter-bank call markets to balance daily cash positions, that is, deploy cash surpluses or borrow to meet the Cash Reserve Ratio (CRR) requirement. While there is sufficient liquidity in the overnight market to enable both lenders and borrowers to meet their respective needs, there remains a nagging fear among cash deficit banks (especially the foreign ones) of not being able to borrow enough to meet the CRR in case of volatility.
This fear creates over-reaction in a crisis and results in increased volatility. It means that decisions on longer tenor assets are taken based on the limited information available in the overnight market. It also causes market inconsistencies, where there should be none. We will look at some of these later.
The second deficiency is the lack of integration with the Foreign Exchange (FX) markets. In order to protect and control the exchange rate of the rupee, strong silos have been created. Forward premium between the rupee and another foreign currency does not reflect theinterest rate differential. If anything, it reflects the estimated risk of depreciation of the local unit against the dollar. This gives rise to significant arbitrage opportunities between the two markets, which are protected through the RBI diktat.
There were no derivatives available on rupee interest rate till a few months back. This situation was redressed by permission to deal in interest rate swaps (IRS). The IRS is now the singular non-cash/non balance sheet product available in the Indian market. At present, the tenors available in the IRS market are short and the benchmark limited to only one, the Mumbai inter-bank offer rate (Mibor). The market is also not yet efficient, so the quotes are disparate and the bid offer wide. This situation should correct relatively quickly, as banks resolve their internal documentation and logistical issues. Trading volumes will increase as nationalised banks begin to participate.
We thus have a range of interest rate products now available over the one to twelvemonth tenor buckets, that is, T-Bills, IRS and forward swaps. These reflect risk-free rates of return and a bank should be indifferent to investing in any of them. However, the yields available vary quite significantly.
The derived swap curve gives by far the largest return, and the IRS the lowest. In developed money markets of the United States or Europe, we see that the T-Bill yields are the lowest and the derived swap curve returns identical to the IRS. Why the anomalies in Indian markets? The IRS yield is low in India, because the IRS product does not suffer from the balance sheet risk inherent in cash markets discussed earlier. It reflects pure price risk, that is, the risk of interest rates changing. Banks' ability to take long positions in T-Bills is constrained by their liquidity conditions. The IRS, as a derivative does not suffer from this limitation. Traders are, therefore, willing to pay a premium to buy an IRS. Globally, funding T-Bills is a relatively simple transaction, as there is nosignificant premium on liquidity. Yields on IRS are higher than T-Bills, reflecting the credit risk inherent in offering this product to an assumed "AA" credit rather than the risk-free nature of sovereign T-Bills.
Derived swap curve yields are high because of the regulatory constraints on arbitraging that particular market. In the current scenario, the bank should borrow INR locally, use it to buy US dollars and then invest the dollars at Libor-linked returns. Simultaneously, it should hedge the re-conversion of the final value of the dollar deposit, that is, principal+interest into rupees at the USD/INR forward rate. The forward rate will be better than the spot rate by the amount of premium received, the benefit of which will also accrue to the bank.
On an aggregate basis, taking the rupee borrowing costs and the dollar 4deposit yield into account, the bank will earn a risk-free arbitrage return. Unfortunately, the RBI limits the extent to which banks can buy and invest dollars. There are alsologistical and liquidity issues in borrowing rupees, or dollars for that matter, from the market. The inability of the market to borrow or short GOI securities, the fear of overnight liquidity, inefficiencies in the financial sector and the high transactions costs in the Indian financial sector will ensure that discontinuities persist or even widen. Some can be easily corrected, as the RBI is doing in case of liquidity through the introduction of the Liquidity Adjustment Facility (LAF) but others are structural in nature. Arbitrageurs looking to take advantage of these spreads do so at their own risk. In fact, the budget has created another anomaly in the financial sector. The subsidised taxation structure afforded to the mutual funds industry, specifically on bond funds, will result in more inequalities and inconsistencies, but that discussion is left for another time.
Copyright © 1999 Indian Express Newspapers (Bombay) Ltd.
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