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Friday, January 30, 2015

Excuses on the Bond-Currency-Derivatives Nexus

What is the Bond-Currency-Derivatives Nexus

The Bond-Currency-Derivatives Nexus is the collection of the following markets:

  • The spot market for government bonds
  • Derivatives on government bonds
  • The spot market for corporate bonds
  • Credit derivatives
  • The spot market for exchange rates
  • Derivatives on exchange rates
  • Complicated products that mix up the above.

These sub-components are sometimes viewed as separate pieces. But they are deeply interconnected. Here are some examples of the interconnections:

  • The investor who buys a corporate bond is getting a bundle of credit risk (i.e. the risk that this firm will default on its obligations) and interest rate risk (i.e. the risk that interest rates will go up thus giving a decline in the price of a bond). Different people view these risks differently. Generally, some parts are hedged off, based on the specialisation of the investor. Some investors think their skill is in credit risk: in this case they will hold the credit risk and hedge off the interest rate risk. This could, further, lead to hedging off a change in the short rate vs. a change in the long rate.
  • A market maker who has inventory of a corporate bond will generally lay off extraneous risks and focus on credit risk. A liquid interest rate derivatives market is required for making liquidity on corporate bonds.
  • A foreign investor buying a rupee denominated bond (either government or corporate) will generally lay off some currency risk: this often generates a paired trade where two things go together: buy a corporate bond and buy protection using currency derivatives. On top of this, there may be an interest rate derivatives play also, as the foreign investor may not like to take the risk that interest rates will go up. A domestic firm issuing foreign currency bonds will generally lay off some currency risk.
  • There are many arbitrages that link up these markets. Covered interest parity is a one-shot arbitrage that links up the currency spot, currency futures, and the bond market. Uncovered interest parity arbitrage gives "carry trade" style structures where borrowing is done in one currency to make investments in the short dated bonds of another country.

This web of interconnections is of essence in thinking about these markets.  E.g. some people think "we should have a good government bond market" but see this in isolation. The insight behind the phrase "Bond-Currency-Derivatives Nexus" is that all these markets are deeply interconnected and should be viewed as one big edifice. It is not possible to sub-divide them. Market makers give liquidity on one security and constantly lay off as much risk as they can using related securities. Hence, liquidity in all these markets feeds into liquidity in all these markets. It is not possible to pick and choose: a country that works to kill the currency market and the government bond market will not have a corporate bond market either. A country that works to kill the currency market will not get a working government bond market. And so on.

What the Bond-Currency-Derivatives Nexus is not

In a recent speech, H. R. Khan, deputy governor of the RBI, said:

It is pertinent to mention briefly a theme current in contemporary discourse- Bond-Currency-Derivatives (BCD) nexus. This is an ideal objective in an open economy financial system. What it means is this: any foreign investor, using any international currency, can buy an Indian Government or corporate liability denominated in Rupees or otherwise and hedge all risks, either onshore or offshore, the attendant credit, interest rate & currency risks. This is a natural prerequisite for free international capital movements, and from an Indian perspective, for mobilisation of the much needed resources. The problem, however, is inherent in the proposition itself. This presupposes complete capital amount openness, particularly for financial institutions& transactions. The pros & cons of full capital account openness is a contentious issue and in any case, we are not ready for it at this point of time. Thus the full BCD nexus has to wait on progress in capital account liberalisation.

This is incorrect. There is no connection between having a well functioning Bond-Currency-Derivatives Nexus, and having full capital account convertibility.

It is feasible to have market development and to have capital controls. As an example, it is feasible to have a world class Bond-Currency-Derivatives Nexus, and also have a capital controls which says (as India does today) that all foreign investment into rupee denominated bonds should not exceed $76 billion. As an example, India has a well functioning equity market while having capital controls on it. As an example, many countries have well functioning Bond-Currency markets while having capital controls.

RBI has failed for 25 years on building the Bond-Currency-Derivatives Nexus. In the paragraph above, they are effectively saying: "Don't blame us for this, as this is about capital account convertibility. At some future date, India will have full capital account convertibility, and after that we will start market development".

The presence of capital controls is no excuse for failure on market development. This failure should have consequences. We require elementary principles of management: The principal (MOF) must take work away from the agent who failed (RBI failed on the Bond-Currency-Derivatives Nexus) and give it to the agent who succeeded (SEBI delivered on the equity market). India's interests are more important than RBI's turf. This reallocation of work is what all the expert committees have proposed, including one by Raghuram Rajan when he was unconflicted.

There are more sensible capital controls (e.g. a Chilean-style tax) and less sensible capital controls (e.g. the Indian barriers against CIP arbitrage). The analysis of capital controls is an interesting and important question. But it is distinct and orthogonal of the mistakes in financial sector policy that have blocked the Bond-Currency-Derivatives Nexus.

Monday, January 19, 2015

Good sense on Docomo vs. the rule of law

by Bhargavi Zaveri and Pratik Datta.

The World Bank's Doing Business report downgraded India's ranking from 140 in 2014 to 142 in 2015. This has not disheartened the government, which continues its campaign aimed at attracting interest in India as an investment and business friendly destination. The campaign has started rubbing off to other arms of government. Even RBI. Recently, the Reserve Bank, in a show of investor friendliness, has reportedly shown an inclination to exempt the Japanese investor, Docomo, from the onerous pricing guidelines applicable to foreign investors exiting India.

While this may bring much cheer amongst investors, such ad-hoc reactions are dangerous for three reasons:

  1. This exemption, if granted, would have legal consequences for India under the bilateral investment treaties that it has signed with several nations.
  2. From a broader perspective, such special exemptions reflect a persistent bias in the Indian executive in favour of the rule of men rather than the rule of law. This usurps discretionary power in the hands of the executive, and increases unpredictability for the economy. This would, ultimately, hurt business.
  3. These patchwork responses sap the energy from the deeper institutional transformation that India desperately requires. We do not need one investment from Docomo, as much as we require for RBI to solve the mistakes of its pricing guidelines. Enforcing the rule of law is more important than doing justice.

The Docomo story so far

RBI has conventionally frowned upon foreign investors having an assured return on equity investments made by them in Indian companies. Typically, a foreign investor is allowed to cash-out his investment through a public listing of the investee company, or failing a public listing, through a put option. A put option allows the investor to put his shares on the Indian JV or the Indian JV partner at a pre-determined price. Until 2013, RBI strongly objected to this exit mechanism. In January 2013, it finally allowed foreign investors to exit by putting his shares on the Indian JV partner or the Indian JV itself. One of the conditions for allowing this exit was that the price to be paid by the Indian JV partner to the outgoing foreign investor could not exceed the market price of the foreign investor's stake, at the time of exit. The foreign investor could not exit at a pre-determined price, the principle being that foreign investors could neither ask for nor get an assured return, for investing in the equity of an Indian company.

Docomo is now in the process of exiting from its telecom JV with the Tatas. The JV agreement between Tata and Docomo reportedly allows Docomo to exit through the put mechanism, at a pre-determined price to be paid by Tata to Docomo. This pre-determined price is reportedly 60% higher than the fair market value of Docomo's stake today. This, being contrary to RBI's policy (as codified in FEMA), the parties applied to RBI for an exemption from the policy. RBI has reportedly indicated its willingness to grant this exemption, although the proposed exit is not in compliance with the existing policy framework, for the following two reasons --

  1. The larger issue, of fair commitment in the contracts in relation to an investment; and
  2. India's relationship with Japan in relation to FDI flows.  

    Understanding the consequences of MFN treatment

    MFN stands for Most Favoured Nation. Bilateral investment treaties that India has entered into with other nations usually contain MFN clauses. When an investment treaty between India and Country A has an MFN clause, India cannot treat investments from Country A less favourably than investments from any other country. In recent past, an Australian investor invoked the MFN clause in the 1991 Australia-India bilateral investment treaty and successfully sued the Indian government.

    RBI proposes to exempt the Docomo exit from the legal restriction on put option pricing. Reportedly, one primary reason for this exemption is the investment relationship with Japan - India happens to be the top investment destination for Japanese firms. RBI (being an extension of the Indian state), in its executive capacity, decided to exempt Docomo because it is a Japanese firm. If this exemption is, in fact, granted, it opens the floodgates for investors seeking similar exemptions, from RBI and the government in future. The refusal to grant such exemptions would amount to treating these investors less favourably than an investor from Japan. This would violate MFN clauses in bilateral investment treaties that India has entered into with the countries of such investors.

    For an analogy, see this case where India was caught in the wrong in 2011.

    The temptation of lapsing into the rule of men

    The rule of law is a subtle and complex concept. All too often, the individuals who man government fall into the trap of doing justice instead of practicing the rule of law. But these are different in important ways.

    The RBI `regulation' imposing pricing conditions for exit of foreign investors does not specifically allow exemptions from the requirement that the price must be not less than the floor specified in the policy. Even assuming that a regulator has an inherent power to make exemptions from its own policy, nobody knows the considerations for judging an application for such exemption. Particularly, in the capital controls regime, the government and RBI have repeatedly succumbed to the temptation of deviating from its own policy, on a case-by-case basis.

    We may point out that while the Indian State repeatedly fails on problems of the rule of law, the lapses are particularly glaring in the field of capital controls. For instance, take the case of allowing FDI in the brownfield pharmaceuticals sector. In 2014, the government prohibited foreign investors from imposing non-compete restrictions on their Indian JV partners, in the brownfield pharmaceuticals sector. However, it retained the power to allow such restrictions in "special circumstances". What these special circumstances are, remains unclear. Neither the law nor the policy gives any guidance to JV partners as to what they should do to satisfy the government that theirs is a "special" case. While it is the government's prerogative to retain discretion, basic governance principles require that the law and the policy clearly specify the conditions on which executive discretion will be used.


    If the government is serious about elevating India's status as a business and investor friendly nation, policymakers must look beyond seemingly well-timed special cases and exemptions. Such short-termism increases policy risk. It sends out the wrong signals that the investment framework in India is susceptible to extralegal considerations. The need of the hour is to take a deeper look at the way policy frameworks are framed and administered, to see whether they infuse certainty in policy administration. A robust rule of law system, instead of arbitrary exemptions, is the only way of improving investor confidence in India.

    This is not an isolated example; it falls within a larger context of difficulties at RBI on thinking about the rule of law and public administration [example 1, example 2, example 3, example 4, example 5]. There is an urgent need for improvements in intellectual capability at RBI on these issues, which are the foundation of sound governance. The IFC would put the ship on the right course.

    Friday, January 16, 2015

    Work on building new government institutions at the Macro/Finance Group at NIPFP

    The Macro/Finance Group at NIPFP is recruiting.


    In March 2011, the Government of India setup the Financial Sector Legislative Reforms Commission to review, rewrite and harmonise financial sector legislations, rules and regulations. In its recommendations, the FSLRC proposed that the draft Indian Financial Code, an umbrella legislation, replace the bulk of existing financial laws and improve the ease of doing business in India. One of the key provisions of the IFC is setting up of various regulatory agencies.

    In order to build these regulatory agencies, the Ministry of Finance, Government of India announced a group of Task Forces. These Task Forces are implementation teams which will design and build these institutions. Macro/Finance Group at NIPFP is the `secretariat' doing implementation for the Task Forces. The positions available are in project management, data analysis, procurement of services, and oversight of external contractors towards building these agencies.

    Key responsibilities

    The key responsibilities of the required personnel are:

    1. Formulate and implement strategies for agency development, including modernisation of business processes, developing business plans, capacity building and specifications for information technology systems;
    2. Design and implement the project plan through which the steady-state agency will be achieved. This includes procuring consulting/IT firms for implementing the plan, and then exercising oversight over them.
    3. Assist in timely and proper preparation of procurement plans and documents for the concerned agency, ensuring adherence to the deadlines and adherence to applicable procurement guidelines;
    4. Perform project management activities including: development and management of work plans, schedules, project budgets and monitoring of consultants;
    5. Participate in other related projects on the implementation of the FSLRC report.

    Qualification and skills

    Graduate or Undergraduate degree from a reputed university with a major in any of the following disciplines - Management, Engineering, or Commerce. Candidates with 3-5 years of experience in the areas of work stated above are preferred.

    Duration of Contract

    Personnel will be appointed on a contractual basis as per applicable rules and norms followed by NIPFP.

    Submission of application

    Interested candidates meeting the above criteria may send their applications to with the following documents attached:

    1. Recent curriculum vitae with complete personal and contact details;
    2. List of references

    Sunday, January 04, 2015

    Opportunities in analytical and policy-oriented finance at IGIDR Finance Research Group

    IGIDR Finance Research Group is engaged in analytical and policy-oriented research in finance. See the papers, the fifth of an annual conference series, and systems. IGIDR FRG has the best data centre for doing high frequency finance with Indian data; this involves big data and computational finance.

    IGIDR FRG supports the Standing Council on International Competitiveness of the Indian Financial System, and is part of the `Bankruptcy Legislative Reforms Commission' (BLRC), chaired by T. K. Viswanathan. These are policy projects of the Ministry of Finance.

    If you are interested in working in analytical, computational or policy-oriented finance, please contact Jyoti Manke <> by 15 January.

    Friday, January 02, 2015

    Are Indian banks systematically mispricing risk?

    by Harsh Vardhan.

    The primary objective of a financial system is to efficiently allocate capital. The key step in allocating capital efficiently is to assess and price risk correctly. Correct pricing of risk ensures that it is properly distributed - capital providers get to hold assets that reflect their risk appetite and present them with an efficient risk-reward trade off.

    Banks are an important vehicle for linking up the savings and investment of India. It is critical that banks price risk correctly. There are concerns about how Indian banks are pricing risk. The chart below shows the average risk premium charged by the banking system on commercial loans in comparison with the risk spreads on various ratings of bonds.

    This shows that private sector banks priced their loan book as if it was rated between AA and A whereas public sector banks priced loans as if they were rated between AAA and A. The risk spreads spiked in FY 2009, the year of global financial crisis. The financial years 2006 to 2008 appear to be `carefree' lending years: there was the biggest ever boom in bank credit, and risk premia were the lowest.

    This analysis may be challenged on several points:

    1. Indian corporate bond markets are not deep enough to provide reliable risk spreads
    2. Loan risk spreads cannot be compared with bond risk spreads as loan covenants are generally tighter than bond covenants
    3. Bank loan books carry a significant retail lending portfolio, which is generally of much lower risk, and hence the risk of the whole lending book comes down

    The first criticism is valid - the bond market is indeed very shallow, and that hampers our ability to read information from it. However, there are two key data points that will throw some more light on this issue. Firstly, in the chart below we show the rating distribution of the top 3 rating agencies in India for the financial year 2009 and 2013. These three agencies account for over 95% of all bonds rated in India. The data shows that the median and mean rating of the bonds was BBB in both the years. The overall rating profile deteriorated over these 4 years. Also, the companies that issue rated bonds are typically larger in size and more established. The firms that banks lend to are, to a greater extent, Small and Medium Enterprises (SME) which are riskier than the large companies that access the bond market. Thus, it is fair to expect that the average rating of the portfolio of banks should be worse than the average bond rating.

    Is this an issue of underestimating the risk, or bad pricing? Unfortunately the analysis does not throw much light on the cause of mispricing. But here is another piece of data that may be insightful. In FY 2012, the Indian banking system had ~ 76 Mn commercial loan accounts (i.e. loan accounts for commercial loans excluding Individual loans). Of these about 72,000 were loan accounts of value above 5 crore, and this subset accounted for 80% of the loans of banks. Currently, around 40% of these accounts are rated by rating agencies. (Under Basel II, banks are allowed to use external rating for their loans). This means that about a 3rd of the loan book by value of the banking system is rated by the same rating agencies that rate bonds. It's unlikely that the ratings agencies use radically different (and lower) standards for rating bank loans. This implies that the cause of underpricing may not be misunderstanding risk but mispricing it.

    The second criticism, of loan covenants assigning better rights to the lender (i.e. banks) than bond covenants is plausible. It is hard to test empirically unless we get the data on recovery rates of loans vs. bonds. I feel that while this is a factor at work, it cannot explain the significant difference between the loan spreads and bond spreads.

    Finally, the criticism about retail loans in the portfolio. It is true that the retail secured lending (eg housing, car loans) has demonstrated a much better risk profile over the last decade or so. However, it is important to note that retail lending constituted about 22% of the overall loan book of Indian banks, and hence the lower risk on retail is unlikely to significantly lower the overall risk.

    I hope to have persuaded you that there is evidence in favour of systematic mispricing. This takes us to the next question: Why would there be such systematic mispricing? There are two possible reasons. First, excessive competition, especially in the larger and relatively better rated lending, that drives pricing down.

    The other reason is more nuanced. Historically, a significant part of the banks' deposits base (~ 33%) was under interest rate regulation - these are the "CASA" (Current Accounts, Savings Account) resources that all banks chase. The chart below presents some interesting analysis. Consider this: if the banking system as whole did nothing but took CASA deposits and invested in the risk free 10 year government security (we call this Risk Free Margin on CASA) then the margin it would make is more or less the same as the pre-tax profits of the banking system! Over the last decade, the risk free margin on CASA was more than the pretax profits of the system except in a few years when the yields on government securities had fallen precipitously - FY 03, FY04 and FY09. This "lazy profit" has been created by regulations. It is this profit pool that allows banks to underprice loans, effectively creating a system wide wealth transfer from (CASA) depositors to commercial borrowers. Most banks use a cost plus approach to loan pricing where the loans are priced at a margin over the cost of funds, which are kept low by interest rate regulation. Despite lifting the SA interest regulation a couple of years ago, only 3 relatively small banks have changed their SA pricing.

    Using sources of funds whose cost has been kept low, because of regulations, to underprice risk in lending, effectively engineers a large scale wealth transfer from depositors to borrowers. This wealth transfer can be interpreted as being an integral part of the system of financial repression which is in operation in India.

    Systematically mispriced risk will result in misallocated capital. Is this one of the reasons that the system regularly runs into NPA crises? Is this systematic transfer of wealth the reason why households avoid bank deposits and prefer to hold other kinds of assets?

    As the Indian economy grows, our financial system should not just grow in size, but also evolve to become more sophisticated and allocate capital more efficiently. With a monolithic system dominated by public sector banks, we have not seen such evolution. Banks today look and behave the same way they did 10 years ago, they are only a lot bigger. Fundamental change in the framework for financial economic policy will give a banking system that allocates resources better, and is safer.