Creating a bond market

The Prime Minister and finance minister have drawn attention to the need for a proper bond market. In a mature market economy, liquidity and market efficiency are found in four markets: equities, currencies, commodities and debt. India has an uncomfortable situation where the only piece of finance that works as it should is the equity market. It has liquidity; and is a source of trustworthy information about future expectations. India needs a bond market to stand alongside this, to have better information for making informed decisions, and to support the fund-raising requirements of government, infrastructure projects and the private sector. Indeed, an efficient bond market is far more important, as a source of finance, than an equity market.

The equity and bond markets have walked on different tracks from 1992. The bond market tried to use the market structure found at the time in New York and London, but limited to a small club of players in South Bombay. Such a market lacks both depth and liquidity, and in many ways is not therefore a real market. In contrast, the equity market tried to look far beyond the habits of New York and London at the time, and employed a strategy with electronic trading, anonymity, nationwide access, low entry barriers and participation from millions of players across the world. There is no doubt about which game plan was superior. The equity market has shaped up with deep liquidity, and speculative price discovery based on expectations about the future. Recent research has demonstrated that, unlike the debt market, the equity market has the resilience of liquidity; when bad news comes along, liquidity does not collapse.

Now that the government is focused on the job, it is easy to get a good bond market going. This requires bond trading on the two major stock exchanges, with the identical principles that have worked well for the equity market. Every existing member of the major stock exchanges should automatically gain access to bond trading, thus eliminating entry barriers to the debt market. Futures and options trading on interest rates should take place, as is the case on the equity market. Banks should be required to place orders on the electronic trading screens of the two exchanges, by having exchange memberships themselves or through brokers. There is no technical problem in the way of this transformation. It only requires taking the task away from the Reserve Bank and handing it over to the stock market regulator and the stock exchanges. This would have the additional advantage of allowing the central bank to focus on monetary policy. The RBI's role in building a bond market should be limited to ensuring technically sound regulation of the bond trading done by banks.

The RBI position on foreign institutional investors investing in rupee-denominated debt also needs to be questioned. Like India, many developing countries have preferred to issue foreign currency-denominated bonds""which is what firms are doing through their external commercial borrowing today. In contrast, when a foreigner buys a share, a government bond or a corporate bond in India, these are denominated in rupees, and the currency risk is borne by the foreigner. It is entirely logical for India to harness such financing. This is a rare low-hanging fruit, an area in which significant progress can be made with little difficulty.