On 15 May 2013, the Reserve Bank of India announced that it would begin monthly issues of inflation-indexed bonds starting June 2013. These bonds, wherein in the principal amount adjusts according to changes in the price level, are already in use in the developed world and their introduction in India is a welcome development. However, they are likely to have different implications for India given the presence of the Statutory Liquidity Ratio regulation in the country.
The Reserve Bank of India (RBI) intends to issue inflation-indexed bonds (IIBs) every month this year with effect from June 2013. The principal amount in the bond will adjust as the price level changes, and a fixed real interest rate on the inflation-adjusted principal amount will be paid on IIBs. The RBI will keep 20% of the issue for retail investors – there will be a separate issue in October 2013 exclusively for retail investors after a discovery of real market interest rates through smaller monthly issues. The RBI plans to raise Rs 12,000 to 15,000 crores ($2.15 to 2.7 billion approx.) through IIBs in 2013-20141. The rest of the money raised by the government will be through the usual non-indexed bonds.
There is a serious shortage of good assets for investment in many developing economies including India, which can have adverse implications (Caballero 2006). The issue of IIBs is a welcome development in this context. For IIBs to be attractive to retail investors, it is important that these bonds provide some minimum real return. But can IIBs provide some minimum real return? Since IIBs are essentially alternatives to non-indexed government bonds, let us first understand the market for non-indexed bonds.
Non-indexed government bonds: Low real yield and high prices
The nominal yield on non-indexed government bonds is about 7.5% at present2. The prevailing inflation rate is also about 7.5%3. So, the realised real yield is almost zero. However, this is not the entire story. Fiscal deficits are very large relative to taxes in the economy. The Standard & Poor’s (S&P) rating of Government of India (GOI) bonds is BBB- with negative outlook4. Similarly, Moody’s has rated government bonds poorly. In this context, we may use the fiscal theory of the price level. This theory argues that if the public debt is large, then the government may be compelled to default not necessarily in nominal terms but possibly in real terms. This can happen if the rate of growth of central bank money gets determined by fiscal considerations at some stage, and the price level gets pushed up. Inflation rate can go up as a consequence. So the prevailing inflation rate at 7.5% is not an appropriate measure of expected inflation. If it is higher, then the current interest rate on government bonds is actually low. More specifically, it is negative. Why then is there so much demand for such bonds?
There appears to be a competitive market in non-indexed government bonds wherein the demand primarily comes from banks. One might think that the interest rate on such bonds is determined in a free market. This is indeed the case except that there is an overriding regulation that works in the background and is often lost sight of - there is the statutory liquidity ratio (SLR) regulation. Banks are required to invest at least 23% of their funds in ‘approved’ (read effectively government) securities. This provides a captive market for government bonds. The result is that bond prices are high. In other words, the real yields are low. The main reason lies in the SLR regulation (Singh 2013).
The usual reason given for SLR regulation is that government bonds provide liquidity to banks. Ironically, these bonds are not liquid for banks - they cannot use bonds which are held under the SLR regulation for liquidity management as they need to meet the requirement! Why then the regulation? The GOI has large fiscal deficits. It needs to finance these in a non-inflationary way at low real interest rates and it needs assured access to funds or ready roll-over facility5. This is where the SLR regulation helps. Banks have to invest. Given that the fiscal condition of the GOI (and that of many state governments) is not very comfortable at present, the SLR regulation cannot be diluted much any time soon.
In practice, banks hold an additional 5-6% of their funds in government or quasi-government securities over and above the mandatory 23% under SLR regulation. This is not surprising because, given the effective ‘illiquid’ nature of the bonds held under the SLR regulation there is a need for some ‘liquid’ securities for liquidity management.
The bottom line is that banks’ demand for government bonds is large. This keeps the yields low. Hence, retail investors are not interested in these bonds (though public authorities often take the view that retail investors are not very aware of government bonds!). It is this differential behaviour on the part of banks and retail investors that is of interest in understanding how the market for IIBs may evolve in future.
Market for IIBs
“It is ... proposed to issue initial series for all categories of investors ...” (RBI 2013, emphasis ours). This implies that banks will be issued IIBs. They will then prefer to replace non-indexed bonds by IIBs as far as they can. This is because the IIBs are expected to attract retail investors and provide a decent return, whereas the non-indexed bonds, as noted above, give low real return. The proposed issue of IIBs worth Rs 12,000- 15,000 crores ($2.15 to 2.7 billion approx.) this year is very small in relation to the size of the existing market for usual bonds, which is very big. The gross and net market borrowing requirements of the Government for the financial year 2013-2014 are set at Rs 5,69,616 crores ($100 billion approx.) and Rs 4,79,000 crores ($84.5 billion approx.) respectively (Ministry of Finance 2013). Thus, the IIBs represent a very small proportion of the total market and will easily get dwarfed. The limited supply of IIBs combined with the SLR requirement on banks has an interesting implication.
The real return on IIBs in a ‘free’ market, which is open to banks, is likely to be very low. This implies that there will be little interest in such bonds amongst retail investors. If this were to happen, it is hoped that the authorities do not infer that IIBs as an instrument are inherently unattractive to retail investors.
It is true that there will be an exclusive issue for retail investors in October 2013. But if yields in the monthly issues from June to October are to be used as a guide for setting interest rates in October, then these are likely to be low. This will further deter retail investors to participate. If the RBI were to settle on a low return in monthly issues from June to October and a high return in the October issue, then retail investors are not likely to participate in the monthly issues prior to the October issue. They will apply and get bonds in October but they may not hold them for long because there can be an arbitrage opportunity. Banks can bid up the prices of these bonds (and bid down the yields) in the secondary market. They will buy IIBs from retail investors who may go back to buy and hold assets like gold! Did anybody think of lock-in period? One hopes not because there will be lack of liquidity for genuine users (and there may be complicated attempts to bypass the lock-in period).
Need to restrict bank participation
The policy lesson from this analysis is straightforward. Given the SLR regulation and the small size of the issue of IIBs, only retail investors (and selected institutional investors like pension funds) should be allowed to participate in the market. There is a need for restriction on participation by banks. Given that they are forced to invest in government securities, they can opt to invest in IIBs, thus bringing the forced element into the IIB market as well. This should be avoided.
The proposed control on participation in the market for IIBs may seem awkward particularly in the context of actual and perceived benefits of liberalisation since the early 1990s. However, the issue is not controls vis-à-vis liberalisation. This is a second best solution in a non-ideal world (Lipsey and Lancaster 1956). Interestingly, with the restriction on banks, interest rates on IIBs may be said to be determined in a truly ‘free’ market. This is not the case with non-indexed government bonds market in which banks are forced to buy a certain minimum.
IIBs are in a sense new even in developed countries. They are still not widely well understood (Campbell et al. 2009).
In India, there is an added complexity - banks are required to observe SLR regulation. This aspect needs to be kept in mind in implementation of IIBs. In this column, I have considered the case for restriction on banks’ participation in IIB markets – a similar argument may apply to mutual funds as well.
- On average, the IIB issue is approx. 2.37% of the gross market borrowing requirement, and approx. 2.82% of the net market borrowing requirement.
- This is the approx. average of 4.9% inflation as measured by the Wholesale Price Index (WPI) and 9.4% inflation as measured by the Consumer Price Index (CPI) (April 2013). Source: http://rbidocs.rbi.org.in/rdocs/Wss/PDFs/09T_WS230513.pdf.
- The credit rating of a bond assesses the credit worthiness or the ability to meet financial obligations/ commitments of the entity issuing the bond. The letter designations such as AAA, BB etc. are assigned by credit rating agencies such as S&P, Moody’s etc. and represent the quality of the bond. A BBB- rating by S&P means ‘lower medium grade’. Bonds rated lower than BBB- by S&P are not considered to be investment grade.
- Roll-over facility means that at the time of maturity, the bond is effectively renewed – it is redeemed and the cash proceeds are re-invested in new bonds. Usually the process works smoothly but there is a possibility that the existing investors may not re-invest. Then the yields can shoot up sharply.
- Caballero, Ricardo J (2006), ´On the Macroeconomics of Asset Shortages´, in The Role of Money: Money and Monetary Policy in the Twenty-First Century. The Fourth European Central Banking Conference 9-10 November 2006, Edited by Andreas Beyer and Lucrezia Reichlin, p. 272-283.
- Campbell, John Y, Robert J Shiller, and Luis M. Viceira (2009), “Understanding Inflation-Indexed Bond Markets”, Brookings Papers on Economic Activity, Spring, p. 79-120.
- Lipsey, R G and K. Lancaster (1956), “The General Theory of Second Best”, Review of Economic Studies, 24(1), p. 11-32.
- Ministry of Finance (2013), ‘Public Debt Management’, Government of India. January. http://finmin.nic.in/reports/Public_Debt_Management.asp.
- Reserve Bank of India (2013), ´RBI Announces Scheme for Inflation Indexed Bonds – 2013-14´, http://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/IEPR1902FSI0513.pdf.
- Singh, Gurbachan Forthcoming, “Is India Hedged against Systemic Risk? An Attempt at an Answer”, Review of market Integration.