Any bond investor knows that money invested in government paper is safer than that in even the best ranked AAA corporate papers. This is the reason why in India, millions of investors still swear their savings to such government schemes as the leitmotif one, the Public Provident Fund (PPF). This is reflected in the difference in yield between government debt and that of corporate bonds. The higher returns on corporate papers, therefore, compensate for the higher risk, and the difference is called the risk premium. If there were no risk, the returns on these too would be the same as on government securities.
This logic, however, does break down, as has happened in the Indian bond market. Just scan the yield data on the benchmark 10-year triple-A rated papers in the US, their counterparts in India, and that of Indian government securities.
At the end of October, the yield differentials of 10-year AAA corporate paper over their government paper equivalents were the same in the US and India. This means the premium on corporate risk in India over sovereign risk was comparable to that in the US market. This convergence in spreads was, of course, partially aided by the liquidity crisis created by the subprime mess in the US. Meanwhile, the spread between Indian and US sovereign bonds has also narrowed sharply in recent years. An American investor, therefore, finds the home risk climate just about the same as in a faraway emerging market like India.
For a fund manager, any debt market investment is a question of a risk-return trade-off. So, a member of this tribe sitting in the US would naturally surmise that the window opened by the Indian debt market is a wonderful slot to push funds through. Is it any surprise that the Indian market is inundated with capital inflows from abroad? It?s not just stocks. FII investment in the debt market has already touched $3 billion (October end). The Securities and Exchange Board of India (Sebi) is flooded with requests from FIIs to prise open the debt window further. The sum involved at this stage may seem far less of a problem than controlling the flood in the equity market. But, globally, the debt market outruns the equity market massively. There is also the minor issue of external debt. Debt inflows, unlike equity, add to our stock of external debt.
In short, the interest rate signals emanating from India offer foreign investors a one-way betting street. The RBI, of course, has explicated the reasons for maintaining a high rate of interest. But in the face of global policy rate cuts, the increased rate gap is creating more problems. What is needed now, therefore, is a lowering of domestic rates, at least for short-term paper. This can only come about if the RBI signals a lowering of its outlook on the interest rate scenario. It will also help the government to moderate the interest cost of running the market stabilisation scheme.
It will also help Mint Street. A steeper yield curve, as a fall in short-term debt rates would imply, will facilitate a more effective transmission channel for policy signals. Bank credit flows can be increased without building up an increasingly risky loan portfolio. The flow of credit, in any case, needs another boost now. Till now, companies have used the equity route to finance their growth, but that cannot continue indefinitely. With the route for external commercial borrowings having being clamped, domestic bank credit has to rise to take its place.
But the perplexity that will still remain is the consistency of the interest rate scenario in the economy. There is no denying the importance of opening up and developing the debt market. But the market?s benefits should not emerge from an unintended policy signal, which can be costly. The rising rupee and one-way bets offered by the scenario just expose the perils of trying to play with too many dummies.