Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

More on Debt Management Office and the Reserve Bank of India

Sankt Ingen responds
to my previous piece
on this subject and asks what is it that the Debt Management Office
can do that the RBI cannot do. Sankt Ingen thinks that I am arguing
for fancy derivatives and similar stuff conjured up by bright young
MBAs. No, what I would like to see is very low brow stuff.

In an institution like the RBI that does something as high brow as
monetary policy and financial stability, the low brow job of peddling
government bonds will never be treated with respect and
seriousness. While the DMO whose sole job is to peddle those bonds
will I hope do that with the same professionalism that an FMCG company
brings to peddling toothpaste.

Yes, I mean that in all seriousness. The job of distributing
government bonds to every nook and corner of the country is as much a
matter of logistics, distribution and marketing as the selling of
detergents and toothpastes. In India (and in many other countries),
the system for distributing toothpastes is far superior to the system
of distributing government bonds (and many other financial
products).

Government bonds are a critical element of the asset allocation
strategies of individuals, companies and institutions. It is a scandal
that their effective distribution is restricted to a handful of elite
institutions.

This lack of diversity of participants is a key factor in the
underdevelopment of the government securities market in India. In
equities, when domestic retail investors are selling, maybe domestic
institutions are buying, and when both of them are selling, maybe
foreign institutions are buying. One wishes that foreign retail could
also participate and bring even greater variety to the market, but we
do have reasonable diversity of players. We did not have this
diversity in the late 1980s or early 1990s in Indian equities and the
markets then lacked the resilience that they have now. At the
slightest shock, the exchanges simply shut down the market to deal
with the imbalance.

When I look at government securities market today, it is just banks
(and LIC at the long end). All banks face the same liquidity shocks
and markets can therefore easily become highly one sided. At a deeper
level, banks are the wrong kind of buyers for long term government
bonds because of the asset liability mismatch. The real reason why
governments borrow from banks is the same as the reason why robbers
steal from banks – that is where the money is easily
available.

The government securities market today is not a market filled with
investors, hedgers and speculators with diverse liquidity needs and
different investment horizons. We have a crazy scheme of small savings
that completely fragments the market by segregating retail investors
in separate instruments altogether. Even the retail trading of
government securities themselves is segregated from the inter bank
market.

The biggest problem is that the RBI does not see investors in
government securities as its customers at all – the banks are
its wards and retail investors are just a nuisance to be segregated in
a tiny and separate corner of the market. I wrote a paper
on this five years ago.

I believe that with the right market design, India can and should
aspire for a government securities market that is deeper and more
liquid than that of the typical emerging market. I think in terms of
the size of the economy, the outstanding stock of rupee government
debt, the existence of a critical mass of financial intermediaries of
reasonable sophistication and the abundance of finance talent in the
country. Yet, the vibrancy that one sees in the equity market or the
commodity derivatives market is lacking in the government bond
market.

I hope that we will get a DMO with a low brow mandate of making
government securities as easy to buy as toothpastes and detergents. I
hope that such a low brow DMO will over a period of several years give
us a deep and vibrant government securities market. This may be a
misplaced hope, but hope is the last thing that I would like to
lose. Anybody who hoped in the 1980s to see a well functioning equity
market would have been dismissed as a day dreamer, but over two
decades, this has indeed come about. Maybe we can repeat that miracle
once again in the market for government securities.

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