Author: Ashima Goyal, IGIDR
India’s pragmatic muddling through in financial reforms has served it well, protecting its financial sector from the extreme collapse seen in the western system. That collapse does not mean we should stop deepening our markets, but it does offer some lessons for the way forward. The focus must be on financial inclusion, development of domestic markets, and their contribution to the real sector.
The cautious stance on capital account convertibility must continue. Our strategy of liberalising equity flows while restricting debt flows has worked well since equity shares in the risk, but debt repayments are heavier in bad times. Emerging markets with a heavy dependence on foreign loans have suffered badly in this and in past financial crises. But there are pressures to further liberalise debt inflows to help develop debt markets and meet government and corporate financing requirements. So the question is, can domestic debt markets be developed without more active participation from foreign investors?
The second attempt to launch interest rate futures is a step in this direction. Reducing the risk of holding or trading debt futures deepens debt markets. A future is a contract to buy or sell an underlying interest bearing instrument at a specific future time and price. These contracts allow exposure to interest rate risk to be laid off.
For example, those long in G-secs can short them in the future thus cancelling out the impact of interest rate fluctuations. But futures also allow speculative positions on an expected future interest rate movement.
Derivatives have become a dirty word after the global financial crisis. So why then are our regulators allowing a new type of derivative?
First, futures are simple standard transparent exchange traded contracts. Complex customised OTC products were at the heart of the implosion in the global financial system. Their impact and risk were poorly understood, and there was no record of aggregate amounts outstanding. But such records are there for exchange-traded products. Moreover, modern exchanges have robust risk and margining systems. During the crisis, although many banks became bankrupt not a single exchange had to close down. Therefore, regulators worldwide now want to encourage more exchange-traded derivative products.
Second, there is a myth that Indian financial institutions escaped the crisis because regulations had stifled markets. On the contrary, development of equity and forex markets was rapid in this decade, and they survived the trial by fire. But the slow liberalisation of debt markets was a deliberate strategy. Foreign debt liabilities have delivered severe shocks to emerging market balance sheets; repayments often have to be made when exchange rates are also depreciating, and interest rates rising in defence. But since debt markets serve needs for long-term finance, developing the internal debt market remains a policy aim.
Third, a precondition for a hedging demand for a product is well-established two-way movement in the asset price. India has moved far from the days when interest rates were administered. Repo rates have recently changed from a peak of 9 per cent to a low of 4.75 per cent. The general structure of interest rates have moved with policy rates, although less. The volatility of Indian interest rates has been increasing over the years and is higher now than in most countries of the world. Therefore, interest risk is high for many types of transactions.
Fourth, interest rate futures are part of the market deepening that will improve the transmission of monetary policy. If the impact of a change in their interest rates on bank balance sheets is lower, they will be willing to change lending rates faster, following a policy rate change. They will not wait, as now, for the bulk of deposits to be given at lower interest rates.
Given these advantages, why did interest rate futures fail to take off earlier? First, the two-way movement of policy rates was not so well established. Second, there were design issues. The theoretical zero coupon yield curve used as the underlying, created too much basis risk. This time liquid ten-year G-secs are to be used. Third, only hedging transactions were allowed. This time pure trade is also to be allowed. Banks are naturally long in government securities, so they are largely sellers of future contracts. Speculators and arbitrageurs create opposite position, making trade possible.
These design problems are being sorted out through interactions with market participants. An unresolved issue is the insistence on physical delivery, which may be problematic as G-secs are not widely held. For example, households are exposed to interest risk through floating rate loans, but do not hold G-secs. Banks could offer them hedging services in a package with housing loans. Or, the contract can be offset before the delivery month.
Interest rates are volatile and the impact of a change is widespread. High volatility makes interest futures attractive; but ironically they will help reduce the volatility. As banks transmit a policy rate change faster, a few basis points’ change can have a larger impact on fresh investment, reducing the need for a large change. The shock delivered by policy is reduced. Deeper markets have lower price volatility. Bid-ask spreads and transaction costs fall. Spreads between deposit and loan rates can also fall as earnings come through volumes, although structural reasons for large spreads also have to be addressed.
By anticipating policy and acting on it markets help policymakers achieve the required change. For example, if markets expect policy rates to rise, bonds are sold reducing their price and raising yields through the term structure. Future prices are used to estimate market expectations. Even so, since markets are subject to bubbles, and when speculative build-ups dominate, policymakers need to deliver an occasional surprise.
The new experiment with interest rate futures will be closely watched. If it works, it implies Indian markets have grown up. They can walk without the foreign crutch that has a tendency to disappear when it is most needed. Foreign participation maybe a useful but not an essential ingredient for markets.
This article also appears here at the Economic Times.