“Our aim is to liberalise steadily, but in a thoughtful way, continuously asking how further liberalisation will strengthen our domestic markets.” Delivering the Annual Day lecture at the FEDAI today, Dr. Raghuram G. Rajan, Governor, Reserve Bank of India explained the rationale behind the measures announced by the central bank on August 25, 2016.

The Governor said that the measures aimed at allowing greater participation to add liquidity in the fixed income market while balancing it with caution in opening up. Thus, greater access was allowed to retail investors, including to FPIs, to institution-dominated screen-based NDS-OM market so that they could trade in G-Secs using their demat accounts; however, “the central bank would continue to be careful about broadening retail access in markets that require sophisticated understanding, such as complex derivatives.” The permission given for a moderate open position to all market participants, the Governor said, would ensure that “we do not get excessive speculation or attempts at manipulation by single traders.” He added that it could also rectify market imbalances, improve exchange market liquidity and depth, without imposing large demands on banks or on the RBI.

Dwelling on the role of regulator, the Governor said that financial innovation was sometimes seen in a bleak light as a way to evade or avoid taxes and regulations. Properly done, however, financial innovation could slice and dice risks so that they were placed on the right shoulders. “The key to the success of this market has been to allow the design of the relevant instrument to be governed by market participants, while ensuring regulatory concerns are satisfied,” the Governor pointed out. He also pointed out that all innovative instruments were not successful and suggested that “Going forward, a level playing field on taxes is warranted for all instruments, so that instruments do not gain favor simply because they get better tax treatment.” An important function for the regulator in encouraging financial innovation was also to create the necessary infrastructure.

Stating that as a current account deficit country, India needed financing from abroad, ideally risk capital, which was in short supply in this country, encouraging Foreign Direct Investment, as well as equity investment was necessary. Foreign investors could also help deepen debt and derivative markets as they contributed to price discovery and liquidity. Yet, given India’s weak bankruptcy system, there was moral hazard built into unhedged foreign borrowing. Therefore, the RBI encouraged companies that did not have foreign exchange earnings to either issue long term dollar bonds, fully hedged shorter term bonds, or rupee denominated Masala Bonds abroad, the Governor explained and hoped that going forward, there would be a more vibrant Masala Bond market abroad to complement a vibrant domestic corporate bond market. It was with a view towards building out an international quasi-sovereign rupee yield curve, so that rupee issuances could be priced easily, that the RBI allowed banks to issue Masala Bonds yesterday, with bank bonds being a good quasi-sovereign proxy, he argued.

Measures, such as, encouraging market making in specific G-Sec instruments by involving Primary Dealers and enabling the RBI to conduct repos of corporate bonds with banks and other financial institutions were aimed at imparting liquidity to these instruments. Hopefully, incidents where a highly rated corporate bond plummeted without warning into default would become increasingly rare as more information was shared through institutions like Credit Information Bureaus and rating agencies exercised due diligence.

As corporations moved to money and bond markets, the RBI would also nudge them further by imposing higher provisioning and capital requirements for banks on corporate lending when exposures become large, the Governor stated . Further, the RBI has allowed banks to offer credit enhancement to bonds issued by infrastructure projects that need substantial amounts of financing but may not start out highly rated. In this context, the Governor also clarified that in order for state government obligations to have zero risk weight, and have the highest rating, it was important that there be no explicit or implicit default or restructuring of such obligations. Pointing out that the regulator has to be careful not to relax prudential regulations simply because an entity or activity was deemed of national importance, the Governor stated that it was far better for the Government to directly subsidise activities that were of national importance like infrastructure if it deemed them important than for the RBI to sacrifice systemic stability.

Alpana Killawala
Principal Adviser

Press Release : 2016-2017/517