G-Sec Market: The Coming Carnage

Updated: Apr 24 2002, 05:30am hrs
In the year ended March 31, 2002, the Indian debt market was throbbing with vibrant activity. Cassandras of doom have been felled by shame and defying gravity, interest rates have continued to move south. The balance sheets of banks, primary dealers and gilt funds have reflected unprecedented profitability. The internal debt management skills of the Reserve Bank of India have been canonised as being astonishingly skillful and perceptive. The theology of the finance minister Mr Yashwant Sinha and the Governor Dr Bimal Jalan has been unequivocal a strong preference for softer interest rates. Market participants have been rewarded by listening to these signals. In the elusive quest for growth, the authorities are chasing a patriotic rate of interest, and a contrarian view on future developments in the financial markets is treated as apostasy.

Let us not believe that the entire blame lies with the authorities. Market players, operating with an extremely short horizon, are equally to blame. Advocates of the low interest rate regime argue that the interest rate parity via the forward exchange premium on the dollar is irrelevant and have all the results in their favour. Forex reserves have piled up at the end of March 2002 to an unprecedented $54 billion and the net foreign exchange assets-currency ratio is a mind boggling 105 per cent. In a world economy crawling along at a snails pace, the Indian economy can surely look forward, with satisfaction, to a 6 per cent growth rate in 2002-03. Inflation continues to be well below 2 per cent and this is not a momentary dip. What else do ungrateful critics want

Industry and government justifiably want lower and lower interest rates and who can deny them this reward The RBI has a stupendous task of putting through a huge gross market borrowing programme of Rs 1,43,000 crore in 2003-03. The RBI opened the borrowing programme in April 2002 with a 7-year and 10-year maturity and a frenetic market obliged with rates of 6.65 per cent and 6.85 per cent respectively. So now we have an interest rate on a 10-year government bond which, adjusted for the forward premia, is clearly lower than a 10-year US government bond. Such is the irrational exuberance of the Indian G-Sec market. The RBI in a mature Open Market Operation, notwithstanding singeing criticism, pushed the 10-year rate back to 7.3 per cent. Market participants have argued that the RBI OMO intervention was unnecessary especially as the RBI has to put through a large borrowing programme. The RBI must be lauded for its sagacity in sensing the dangerous waters that market participants have entered into and, therefore, the Bank was right to lean against the wind.

Now let us look at the structure of interest rates on government paper. The 91-day and 364-day treasury bills have yields below the call market rates. The 10-year rate is 7.3 per cent and the 20-year rate is 7.8 per cent. It is unfair to criticise the RBI for going in for a uniform price auction for the opening issues for the current year. Market participants should have been more judicious in their bids. The uniform price auction was no reason for the market to reduce the 10-year security cut-off yield to 6.85 per cent.

Market participants ought to seriously reflect on the possible future course of interest rates. Governor Jalan in his Mid-Term Review of Monetary and Credit Policy for 2001-02 in October 2001 had said ....banks, primary dealers (PDs) and other market participants must explicitly take into account that the interest rate environment can change quite dramatically within a very short period of time... Difficulties faced by banks, PDs and other market operators in the first quarter of the last fiscal year, ie 2000-01 when interest rates had to be increased by RBI (in order to check volatility in the foreign exchange market consequent upon sharp and frequent increases in the international interest rates) provides a valuable lesson in this regard. Furthermore Deputy Governor Dr Y V Reddy has recently warned that banks and PDs should moderate their reliance on call money as a source of funding longer term assets.

Banks and PDs are, however, suffering from a Pavlovian neurosis as, notwithstanding this salutary advice of caution to market players, the authorities have been ambivalent by reiterating their preference for softer interest rates. The G-sec market is clearly at the turning point of the interest rate cycle, yet the belief is that there are large and continuing profits to be made by forcing down interest rates. The RBI has taken a courageous step in knocking sense into security market players by edging up interest rates through the OMO. The time is now apposite for the RBI to give a coherent and unswerving signal that the G-Sec market is now at a point where there can be large losses to market players and, therefore, players should drastically reduce their reliance on money market resources to fund their assets.

The suicidal tactics of market participants can no longer be ignored. In a situation where banks and PDs are jumping over the cliff in a mass hara kiri, it would be a dereliction of duty on the part of the RBI if it did not put a clear quantitative cap on money market borrowings by banks and PDs. A namby-pamby statement on money market reliance will not do; what is necessary is an unequivocal statement by RBI of policy intent. It is not as if the borrowing programme would not go through if there was such a clamp. All that a restraint would do is to moderate wild and unrealistic bidding at the auctions by banks and PDs.

Is the explosive increase in trading volumes legitimate or will there be heavy casualties when the music stops A carnage in the G-Sec market in India over the next 12-24 months is not only likely but necessary to bring back an element of financial discipline and prudence. Unequivocal caution by the RBI would result in some blood letting as part of a market correction. While inaction by the RBI on April 29, 2002 could be of comfort to market players in the medium-term, there would be rivers of blood in the G-Sec market. It is said that those whom the gods wish to destroy, they first make them mad. The RBI must act here and now to stop this lunacy.