EVOLUTION AND DEVELOPMENT OF DEBT MARKETS IN INDIA

Mentor – Ms. Naisha Sujan

Financial Systems in India

The economic development of any country depends upon the existence and working of its financial system. The financial system provides inputs required for the production of goods and services. Financial markets and Financial institutions are a part of this financial system.

The financial system mobilises savings in the form of money and monetary assets. These savings of the individuals are invested in productive activities. Thus it converts savings into investment. Thus the financial system is the intermediary between savers and investors that promotes the overall economic development of the country.

The financial system mainly performs two functions:

i. Provides liquidity- liquidity refers to cash or ability of easily converting an asset into cash. In India, RBI has the sole authority to issue coins and currency notes. Commercial banks and Financial institutions also perform the function of credit creation. But, the RBI has control over the creation of credit and on the money supply in the economy. Therefore, it is the leader of the Indian Financial System.

ii. Mobilises savings- the financial system mobilises savings from the individuals. These savings are channelized and invested in productive activities. The system should provide appropriate incentives to attract individuals for the savings. Thus the financial system mobilises savings and converts them into investment.

Financial Markets in India

Financial markets can be reffered to those centres and arrangements which facilitate buying and selling of financial assets like shares,debentures,bonds,mutual funds,etc. However, incase of stock exchange there is specific place or location for the financial market.The Industrial Securities market can be divided into two parts:

i. Primary market or New issue market- primary market is the market for new issues of financial instruments. Therefore, it is also called as new issue market. It deals in those securities which are issued for the public for the first time.There are three ways in which securities are issued in this market:

Public issue- this is the most common and popular method of raising capital by new companies.

Rights issue- when existing companies want to issue securities to public,they are first offered to the existing shareholders.

Private placement- it is a way of selling securities privately to a small group of investors.

ii. Secondary market or Stock exchanges- securities which are already issued in primary market are traded in secondary market. Generally, these securities are listed on stock exchanges and through the stock exchanges they are traded. All stock exchanges in India are regulated under the Securities Contract Act,1956. The Bombay Stock Exchange is the principal stock exchange among all the stock exchanges.

Debt Markets in India

The debt market is any market situation where trading of debt instruments takes place. A debt market establishes a structured environment where the debt instruments can be traded with ease between interested parties. Debt market is called by different names, based on the types of debt instruments that are traded:

Bond market- if the market deals mainly with the trading of municipal and corporate bond issues, the debt market may be known as a bond market.

Credit market- if mortgages and promissory notes are the main focus of the trading, the debt market may be known as a credit market.

Fixed income market- when fixed rates are connected with the debt instruments, the

market may be known as a fixed income market.

Debt instruments Government securities- it is the RBI that

issues G-secs on behalf of the Government of India. These securities have a maturity period of 1 to 30 years. G-secs offer fixed interest rates, where interests are paid semi-anually. For shorter term, there are T-bills which are issued by the RBI for 91/182/364 days.

Corporate bonds- these bonds come from private corporations and are offered for an extensive range of tenures upto 15 years. Comparing to G-secs, corporate bonds carry higher risks, which depend upon the corporation, the industry where the corporation is currently operating, the current market conditions and the ratings of the corporation.

Certificate of deposit- they usually offer higher returns than the bank. They are issued in demat form. Banks can offer CD’s which maturity between 7 days and 1 year. CD’s from financial institutions have maturity between 1 to 3 years.

Commercial paper- they are short term market instruments. They are issued by companies, primary dealers and financial institutions. The investors get good amount of returns from commercial papers as compared to bank deposits. The maturity period is between 7 days to 365 days.

Evolution of the Indian debt marketTill 1991, money was collected and lent according to Plan. If planning went awry, the government approached RBI, its banker. The central bank made a few phone calls to the heads of banks and bonds were issued and the money arranged. No questions asked, no explanations given. If anybody wanted a loan, they approached the banks to borrow money at fixed rates. That, in short, was the debt market in India ten years ago.From the rudimentary form of a debt market then to the threshold of vibrant, real-time trading in a range of debt instruments, the journey has been long but rapid. The contours of the debt market began taking shape in the late 1990s when the government started borrowing at market rates. Slowly, but steadily, the market grew,

adding fresh players and novel instruments. The growth of the debt market, in terms of participation, competition, depth and range, has been phenomenal.Today, the size of the Indian debt market is a mammoth Rs 6.5 lakh crore, including outstanding government debt, and is gradually attaining a level of sophistication comparable to some of the other world markets.While in 1996 there were around six PDs (primary dealers), today there are 18. The debt market is growing and deepening and this is also indicated by the fact that it has given benchmarks to other money market instruments such as the CPs and inter-corporate deposits. With proper infrastructure in place, our markets will truly be integrated with international markets in future. The apex bank issued floating rate bonds of short maturities which were an instant hit in the market.

There are three main segments of debt markets in India: Government securities- the market of government

securities is the most dominant of part of the debt market in terms of outstanding securities, market capitalization, trading volume and number of participants. It sets a benchmark for the rest of the market. The market for government securities comprises the Centre, State and State sponsored securities. In the recent past, local bodies such as municipalities have also started issuing the debt securities to satisfy their needs for funds.

Public sector units bonds- it is the second segment of the debt markets. The bonds issued by these bodies are generally tax free, while most of the bonds including government securities are not tax free. The RBI also issues tax free bonds, called the 6.5% RBI relief bonds. These bonds are also popular as they are tax free bonds.

Corporate securities- corporate bond markets comprise of commercial papers and bonds. These bonds typically are structured to suit the requirements of investors and issuing corporate. They offer different features in respect of interest payments and redemption. Until 1992, interest rates on these corporate bonds were regulated. After the de-regulation of interest rates in 1992, bonds with varied options/features are issued. The major part of the corporate debt is privately placed with tenures of 1 to 12 years.

Pre-reform period

In India, fiscal policy compulsions rendered internal debt management before 1991-1992 which was passive. To keep government borrowing costs down, low coupon rates were offered on government securities, which made real rates of return negative for several years till the mid-1980s. During the 1980s, the volume of debt expanded considerably, particularly short term debt, due to automatic accommodation to Central government by the Central Bank(RBI) ,through the mechanism of ad hoc Treasury Bills. With a captive investor base [through Statutory Liquidity Ratio (SLR) prescription, mostly] and interest below the market rate, secondary market for government bonds remained dormant. Artificial yields on government securities affected the yield structure of financial assets in the system, and led to higher lending rates. Driven by these compulsions, Reserve Bank’s monetary management was dominated by a regime of administered interest rates, and rising Cash Reserve Ratio (CRR) and SLR prescriptions. High CRR and SLR left little room for monetary maneuvering. It is against this backdrop, and in the context of the overall economicreforms, that development of the government securities markets was initiated, in the 1990s.

Post reform development

The development of government securities market reflects a transition from passive to active debt management by the RBI. The reforms undertaken by the Reserve Bank since 1990s can

be briefly viewed as a systematic exercise for the development of the debt market as well as integration of the entire financial markets by making it deep, wide and transparent.The reforms aimed at increasing the operational autonomy of the RBI by measures, such as, abolition of automatic monetization through ad-hoc Treasury Bills (in 1997) and its replacement by Ways and Means Advances facility, with limits, to meet temporary cash flow mismatches for the Central Government. The elimination of automatic monetisation was considered critical in the stabilization policy.Secondly, government borrowing was made market based through the introduction of auction system in primary issues.Thirdly, improvements in institutional infrastructure were sought to be achieved through the setting up of system of Primary Dealers.Fourthly, the breadth and depth of markets were sought to be improved by introduction of a variety of new instruments viz., Zero Coupon Bonds, Capital Indexed Bonds, Floating Rate Bonds, Call and Put Option Bonds, etc. Fifthly, since April 1999, the Reserve Bank has been actively pursuing the consolidation of debt through reissuance/reopenings through price based auctions. This has greatly improved the market liquidity and helped the emergence of benchmark securities.Sixthly, trading and settlement systems have been improved through introduction ofDelivery-versus-Payment (DvP) system and operationalisation of Negotiated Dealing System (NDS) and Clearing Corporation of India Ltd. (CCIL).

Finally, a retail market in government securities is sought to be promoted through a system of non-competitive bidding at primary auctions.

Developments in market infrastructure

Securities settlement system- Settlement of government securities and funds is being done on a gross trade-by-trade Delivery vs. Payments (DvP) basis in the books of Reserve Bank, since 1995. A Special Funds Facility from Reserve Bank for securities settlement has also been in operation since October 2000 for breaking gridlock situations arising in the course of DvP settlement.With the introduction of Clearing Corporation of India Ltd (CCIL) in February 2002, which acts as clearing house and a central counterparty, the problem of gridlock of settlements has been reduced. To enable Constituent Subsidiary General Ledger (CSGL) account holders to avail of the benefits of dematerialised holding through their bankers, detailed guidelines have been issued to ensure that entities providing custodial services for their constituents employ appropriate accounting practices and safekeeping procedures.

Negotiating dealing system- A Negotiated Dealing System has been

operationalised effective from February 15, 2002. In Phase I, the NDS provides on line electronic bidding facility in primary auctions, daily LAF auctions, screen based electronic dealing and reporting of transactions in money market instruments, facilitates secondary market transactions in Government securities and dissemination of information on

trades with minimal time lag. In addition, the NDS enables "paperless" settlement of transactionsin government securities with electronic connectivity to CCIL and the DvP settlement system at the Public Debt Office through electronic SGL transfer form.

Clearing Corporation of India Limited -The Clearing Corporation of India Limited commenced its operations in clearing and settlement of transactions in Government securities (including repos) with effect from February 15, 2002. Acting as a central counterparty through novation, the CCIL provides guaranteed settlement and has in place risk management systems to limit settlement risk and operates a settlement guarantee fund

backed by lines of credit from commercial banks. All repo transactions have to be necessarily put through the CCIL, while all outright transactions up to Rs.200 million have to be settled through CCIL ( Transactions involving larger amounts are settled directly in RBI)

Transparency and Data Dissemination-To enable both institutional and retail investors to plan their investments better and also to provide further transparency and stability in the Government securities market, an indicative calendar for issuance of dated securities has been introduced in 2002. To improve the information flow to the market Reserve Bank announces auction results on the day of auction itself and all transactions settled through SGL accounts are released on the same

day by way of press releases/on RBI website. Statistical information relating to both primary and secondary market for Government securities is disseminated at regular interval to ensure transparency of debt management operations as well as of secondary market activity. This is done through either press releases or Bank’s publications viz., (e.g., RBI monthly

Bulletin, Weekly Statistical Supplement, Handbook of Statistics on Indian Economy,Report on Currency and Finance and Annual Report).The Reserve Bank is the initial signatory of Special Data Dissemination Standards of IMF and places substantial information and statistics on its website.

New Instruments

Plain vanilla securities- Plain vanilla securities cover Debt where the issuer is obliged to pay the holder of the security 100 % of the redemption amount, as well as a potential coupon payment.They always have a fixed redemption amount but can have different coupon structures built into them such as fixed, index linked or floating coupon payments.

Fixed coupon bonds- These are bonds on which the coupon rate is fixed for the entire life of the bond.  Most Government bonds are issued as fixed rate bonds.

Zero coupon bonds- A zero-coupon bond (also called a discount bond or deep discount bond) is a bond bought at a price lower than its face value with the face value repaid at the time of maturity. It does not make periodic interest payments, or have so-called "coupons," hence the term zero-coupon bond. 

Capital indexed bonds- These are bonds, the principal of which is linked to an accepted index of inflation with a view to protecting the holder from inflation. The government is currently working on a fresh issuance of Inflation Indexed Bonds wherein payment of both, the coupon and the principal on the bonds, will be linked to an Inflation Index (Wholesale Price Index). In the

proposed structure, the principal will be indexed and the coupon will be calculated on the indexed principal.

Floating rate bonds- Bond whose interest amount fluctuates in step with the market interest rates , or some other external measure. Price of floating rate bonds remains relatively stable because neither a capital gain nor a capital loss occurs as market interest rates go up or down.

Call and put option bonds- A callable bond (also called redeemable bond) is a type of bond (debt security) that allows the issuer of the bond to retain the privilege of redeeming the bond at some point before the bond reaches the date of maturity. In other words, on the call date(s), the issuer has the right, but not the obligation, to buy back the bonds from the bond holders at a defined call price. A put bond is a relatively unusual bond that allows the holder to force the issuer to repurchase the security at specified dates before maturity. The repurchase price, usually at par value, is set at the time of issue. A put bond allows the investor to redeem a long-term bond before maturity, but the yield generally equals the one on short-term rather than long-term securities.

Conclusion

Debt management in India has clearly come a long way from a passive system to a market driven exercise with developed institutions, instruments and markets.

India ranks on par with some of the developed countries in areas like institutional framework, risk management

set-up, market  development, clearing and settlement procedures and transparency in debt management operations