Untangling debt market’s doors

There is a need to proceed cautiously in fully opening the debt market to foreign investors, given the need to first deal with issues such as capital controls and large government borrowings, said Reserve Bank of India (RBI) Executive Director G Padmanabhan in a speech last week at Brussels.

He also voiced concern over unhedged foreign currency exposure of Indian borrowers in offshore debt, saying it raised “systemic concerns”.

“At a micro level, individual entities may well be able to tide over any exchange rate shock but at a macro level, when everybody scurries for cover, the market impact may be unsettling,” he said.

Padmanabhan cited “structural frictions” in India’s bond and currency markets, including large government borrowings, as reasons that justified proceeding in a non-disruptive manner on the issue of enhancing debt limits for foreign investors. Currently, they can buy up to $ 30 billion of government bonds and $ 50 billion of corporate bonds.

Every year, the rupee has been depreciating at about five per cent, while the present cost of a swap is six to seven per cent. Padmanabhan says this acts as a disincentive. “There is a need to align individual incentives with that of the system. Use of options and what is called option trading strategies can contribute and, therefore, the regime has to consider permitting this,” he said.

Two things RBI was actively considering in this direction, he said, were permitting covered option writing and relaxing the net worth criteria for using option strategies to hedge exposure.

Currently, capital account convertibility is not permitted. Padmanabhan believes unless liberalisation here is accompanied by achievement of certain ‘thresholds’ and financial and institutional developments, the costs might far outweigh the benefits.

On the complexities of derivative products, Padmanabhan said banks would have to put in place a framework for testing if the product is appropriate for clients. “The Exchange Dealers’ Association of India has an important role to play in this. The idea must be to prevent mis-selling, rather than penalise such actions. Recently, it came as a great shock for me to learn that some of our exchanges do not have systems to upfront prevent self-trades. They rather believed in tracking and penalising self-trades. This, to my mind, is an inefficient approach to the issue,” he said.