DEBT MARKETS Roughly 90 percent of the Indian fixed income market is made up of bonds issued by the government of India (GOI). The GOI bond market capitalization grew sharply from 1 trillion rupees in 1995 to 11 trillion rupees in 2004. In part, this reflects India's fiscal problem, in which the fiscal deficit grew from 0.48 trillion rupees in 1995 to 1.30 trillion rupees in 2004. Both government and corporate bonds are held and traded locally. There are no GOI bonds that trade in international markets. Indian firms do raise money in international markets, but these are typically held to maturity or are traded in very illiquid markets.
The maturity of GOI bonds ranges from three months to fifteen years. Bonds with maturity greater than a year are issued with a fixed coupon, which is set to roughly obtain a par bond (a price of Rs. 100) at the date of issuance. There are practically no zero-coupon, indexed, or floating rate bonds. While the short-maturity bonds are more or less issued on a calendar fixed at the start of the year, longer-term bonds have no such schedule. New issues tend to create new kinds of bonds: there is little effort to consolidate the liquidity into a smaller set of bonds. On average, there tend to be between 140 and 170 bonds that are available in the GOI bond market. The market is concentrated among five kinds of finance companies: banks, insurance companies, pension and mutual funds, and (as an intermediary) primary dealers. Strong entry barriers exist, which have prevented wider market access.
Bond trading takes place through the telephone. It is an over the counter market with trades negotiated directly between two finance companies or intermediated by a broker. There is no pretrade transparency. Reliable information about the day's trades becomes available only by the end of the day. Roughly half of the trades, particularly those that involve brokers, are reported on the NSE WDM (the Wholesale Debt Market of the National Stock Exchange). Irrespective of whether a trade is reported on WDM, it is transmitted into the systems for clearing and settlement through the Negotiated Dealing System (NDS), which is a computer front-end screen linked to a computer network, run by the Reserve Bank of India.
Most (though not all) trades flow through NDS to the Clearing Corporation of India Limited (CCIL), which was established in 1999 to remove counterparty default risks for GOI trades. CCIL becomes the legal counter-party to both legs of all trades, removing risk and externalities associated with default by one counterparty. This is unusual by world standards, since netting by novation is typically a feature of exchanges and is not found in an over-the-counter market. CCIL has enabled multilateral netting in the settlement of trades, meaning that the multiple fund or securities obligations of a single entity (to pay or receive) are aggregated into a single net obligation. Prior to the creation of CCIL, the bond settlement process was much less reliable.
One significant development has been the emergence of exchange-traded collateralized borrowing and lending obligation (CBLO) contracts at CCIL, similar to funds borrowing backed by securities, or a repurchase agreement (repo), with maturities from a day to a year. However, unlike the repo, which is traded on an over-the-counter market, the CBLO is traded on a limit order book exchange and has had a volume of 25 billion rupees in a very short period. This is India's first accomplishment in terms of opening up market access, and having a more transparent trading framework.
The turnover ratio, defined as trading volume over a year divided by market capitalization, went up sharply from 8 percent in March 1995 to 192 percent in 2002. Bond market liquidity lacks resilience; when bond prices decrease, liquidity tends to evaporate. The turnover ratio dropped to 152 percent in March 2004, and dropped further in the first half of 2004–2005. Trading was fragmented due to the large number of bonds with heterogeneous maturity and coupons. As a consequence, liquidity tends to be concentrated in a certain maturity of bonds at a given time.
A major driver of the liquidity in the corporate bond market—as well as the GOI bond market—has been the emergence of fixed income mutual funds in the late 1990s. Mutual funds are much more accountable, thanks to daily computation and disclosure of the value of the bond portfolio. In addition, the mutual fund industry has become largely private since the 1990s.
The Indian fixed income markets urgently need instruments to hedge against interest rate volatility. In a market economy, fluctuations of interest rates are innate. At present, there is little flexibility for firms and households to manage this risk. There has been significant growth in the over-the-counter market for interest rate swaps as well as forward rate agreements. Open positions rose from 2.4 trillion rupees in 2003 to 5.2 trillion rupees in 2004. However, this market lacks a modern legal and regulatory framework. There are continued concerns that the contracts on this market are not enforceable under Indian law. There have been attempts to start exchange-traded interest rate futures, but these have been unsuccessful.
The central bank, the Reserve Bank of India (RBI), has a dominant role in defining India's bond market. There is no explicit mandate for this role in the Reserve Bank of India Act of 1934. However, the RBI is the issuer of bonds and debt manager for the government of India. It runs the depository (Securities General Ledger) where GOI bonds are dematerialized and held. Since the RBI is also the regulator of banks, it has an overriding influence on policy questions about the bond market through the use of regulations that prevent banks from moving toward a market design considered unsuitable to the RBI. Therefore, the RBI has become the regulator by default because of all its other roles. Insights into many problems on the bond market can be traced to this institutional framework. The corporate bond market is regulated by the Securities Exchange Board of India, which is the securities market regulator.
Darbha, G., S. D. Roy, and V. Pawaskar. Idiosyncratic Factors in Pricing Sovereign Bonds: An Analysis of the Government of India Bond Market. Technical report, National Stock Exchange of India, Ltd. 3, 2002. Available at <http://www.nse-india.com>
Subramani, V. and G. Ananth Narayan. Derivatives Markets in India 2003, edited by S. Thomas. New Delhi: Tata McGraw-Hill, 2003.
Thomas, S., and V. Pawaskar. Estimating a Yield Curve in anIlliquid Debt Market. Mumbai: Indira Gandhi Institute of Development Research, 2000.