An imperfect bonding

Retail participation in govt bonds needs reforms

The Reserve Bank of India (RBI) has taken another big step to encourage retail participation in the government bond market by sharing details of the Retail Direct Scheme, which was announced in February. Individual investors will now be able to open a “Retail Direct Gilt Account” directly with the central bank to buy government bonds. The account can be opened through an online portal after fulfilling the mandatory know-your-customer requirements, and individual investors will be able to buy the government of India treasury bills, dated securities, sovereign gold bonds, and state government bonds. This initiative by the RBI must be welcomed because it will allow individual investors to directly participate in the government bond market. Only a few countries offer such an option.

The idea clearly is to increase the ease of investing for retail investors, which will also help broaden the investor base for government bonds. The RBI has taken several steps in the past — such as allowing non-competitive bidding in the primary auction — to increase investor participation in the bond market. Government borrowing has increased substantially, particularly due to the Covid-induced disruption, and the hope is that an increased pool of investors will help the RBI complete its borrowing programme more smoothly. Even if government borrowing is at a lower level, a bigger pool of investors will help and allow the government to borrow at a lower cost. However, the reality might turn out to be somewhat different.

Ironically, the RBI’s own action and policy management may end up discouraging most retail investors. The Indian central bank has pushed real interest rates into negative territory and is supporting government borrowing through market interventions. It is holding market interest rates at lower levels to support growth, but individual investors may not be keen to buy government bonds offering negative real returns. Further, bond yields are not particularly attractive compared to bank fixed deposits. The yield on five-year government bonds is at about 5.7 per cent, while State Bank of India is offering 5.4 per cent on deposits for a similar duration. Retail investors also have the option of small savings instruments. The five-year National Savings Certificate, for instance, is offering a 6.8 per cent rate of interest. It will not make much sense for retail investors to invest in government bonds with lower returns and expose themselves to market fluctuations. It is highly likely that investors will suffer capital loss in longer-term bonds because interest rates will go up from the present level.

Besides, if households shift part of their debt portfolio to government bonds, it will affect demand from other segments. Banks will have that much less to buy government bonds if households reallocate their savings from fixed deposits to government bonds. This is not to suggest that the platform will not attract investors. However, to increase retail participation in a meaningful way, both the RBI and the government will need to reduce the level of financial repression in the system. In fact, market-determined rates will increase efficiency in the financial system as more participants compete for household financial savings. Better rates will also encourage households to put their savings in financial instruments, which will help push up real investment and growth. But without necessary groundwork and reforms, the new platform will not add much value.