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Sunday, July 27, 2008

When the agency that sets the short-term interest rate is also selling bonds

Anup Roy has this fascinating article in Mint:

Ahead of the quarterly review of monetary policy on 29 July, the Reserve Bank of India (RBI) auctioned Rs6,000 crore worth 10-year bonds on Thursday at a cut-off yield of 9.0785%.


Following this, the benchmark 10-year bond yield, which was trading at 9.01% until late Thursday afternoon, rose to 9.09%.

While it is not exactly an indication of market expectations from the monetary policy to be unveiled next week, bond dealers say they are trying to figure out the underlying meaning of two important moves of the central bank involving the auction.

For the first time, buyers of govt bonds had to bid without being aware of the latest inflation figures

RBI was originally slated to auction a 14-19 year bond but, later pared the maturity to 10 years. It has also used the uniform pricing method to auction the bonds after a gap of two years. Normally, government bond auctions follow the practice of multiple pricing.

This is also for the first time the buyers of government bonds, such as banks, insurance firms and primary dealers, had to make bids without being aware of the latest inflation figures.


One can interpret the paring of maturity of the bond as a signal from the banking regulator on the interest rate outlook. The rates will go up and it does not want financial intermediaries to lock themselves in for longer period as they will have to take the hit and make good the depreciation in value of bonds, said a dealer who didnt want to be named.

J. Moses Harding, head of the wholesale banking group at IndusInd Bank Ltd, also echoed the same view. Probably RBI is taking a view that interest rates are on the higher side, he said. So, why lock in for a longer period and pay more?

Some other dealers say the central bank shifted to a 10-year bond for the auction because of the low demand for longer term papers. Insurance companies that generally buy longer term papers, dont have much surpluses to buy longer term bonds, said Harihar Krishnamurthy, head of treasury of Development Credit Bank Ltd.

According to Joydeep Sen, vice-president, advisory desk of BNP Paribas, the auction of a 10-year paper instead of a longer term bond, is possibly to reduce the borrowing cost of the government as longer bonds command higher interest rates.

Possibly the government is trying to fine-tune its borrowing cost and it also wants to issue more liquid papers to boost the sentiment, Sen said.

Under uniform price method, all successful bidders receive the bonds at the cut-off prices irrespective of their biddings while in multiple price auctions, bidders receive bonds at their bidding prices as long as they are within the range of the cut-off price.

According to bond dealers, the uniform pricing was adopted to shield investors from higher volatility.

Probably RBI wanted a better pricing. Uniform pricing normally ends up at slightly more bullish than multiple pricing. You dont have the bidding risk or winners curse there, said A. Prasanna, vice-president, ICICI Securities Primary Dealership Ltd, a firm that buys and sells bonds.

A winners curse happens when a bidder overpays to buy bonds in multiple auctions. In case the prices go down, the aggressive bidders lose the most.

The government wants to raise Rs96,000 in bonds in the first half of the financial year. So far it has raised some Rs66,000 crore.

A NewsWire18 story of 22 July quoted an unnamed finance ministry official as saying that the bidding was done on Thursday to beat release of inflation data.

The market is full of questions and speculation. Why was the date of auction not changed though inflation data release changed? Why was a 10-year bond issued instead of a 14-19 year bond as originally slated? Why was uniform pricing introduced? Since RBI is both central banker and investment banker to the government, do these decisions of RBI reflect knowledge of the future course of monetary policy being utilised to lower the cost of financing for the government?

You might be inclined to dismiss this newspaper article as reporting market gossip. But this kind of market gossip is a measure of the thinking of the market.

When the market is faced with these kinds of uncertainty, it ultimately damages the interests of government as an issuer. A customer is willing to pay more for a bond (i.e. a lower interest rate) when he is confident about what is going on. When a customer is confused (through lack of transparency) or worried that he's being had (through conflicts of interest), bond prices will be lower (i.e. the cost of financing will be higher) so that the customer is given a discount in return for the greater risk that he is facing.

This episode vividly illustrates the consequences of the mistakes in India's financial architecture. The investment banking function for the government should not be placed with the central bank. Markets must feel that the investment banker has not the slightest links to monetary policy. The investment banker must not have an inside track on knowing the future course of interest rates. When markets feel confident about this, when they know that the investment banker to the government is not playing games with them, markets will supply financing to the government at a lower cost.

There are exactly three ways to organise the debt management function:

  1. To use the architecture of the RBI Act of 1934 (conflict of interest between monetary policy and investment banking), and then suffer from higher cost of financing for government as a consequence.
  2. To use the architecture of the RBI Act of 1934 (conflict of interest between monetary policy and investment banking), but forcibly obtain low cost financing for government through financial repression -- i.e. forcing financial firms to buy government bonds.
  3. To separate out the investment banking function into an independent Debt Management Office (DMO), which has no links with the central bank. This will reassure markets that the moves of the DMO do not reflect game-playing by the DMO based on a knowledge of the future direction of interest rates. This has been recommended by several expert committees, including the Mistry committee.

This is an example of what a proper institutional architecture is all about. In a mature market economy, the various functions of the State are placed in agencies without conflicts of interest. Each agency has a clear role and clear accountability, and operates with full transparency. In India, our landscape is filled with obsolete laws and obsolete architecture. Becoming a mature market economy is critically about making changes to the financial architecture.


  1. A thoughtful piece.
    What parts of the Mistry Committee recommendations, do you think can be quickly addressed, with least political and beauracratic frictions? Would love to read your take on that.

  2. Ajay,

    Why do you wish to move India to a model which clones the western economy bit by bit? It is clear that their financial shenanigans have put the world at great risk. Yet, you are still their cheerleader. Why can't we selectively pick and choose the best while still retaining our innovations?

  3. Satsheel: A lot of the MIFC report can be done without legislative changes. But a good chunk of it does require legislative changes.

    Amit, this can be answered at three levels.

    First, a country like the US turns out an incredible $45,000 a year of per capita GDP while India is at one-twentieth of this number. So if one had to blindly mimic what is done in industrial countries, it still does a world of good in eliminating mass poverty in India and putting India at a totally different level. As a first approximation, it is *we* who are way off on what should be done, and not them. With all their financial shenanigans, the fact remains that (a) they are holding high per capita GDP and (b) US GDP growth this year will be just 1 to 1.5 percentage points below long term trend.

    Second, it is basic logic and common sense that the agency which sells bonds should not set interest rates. This ought to be done whether or not the industrial countries do it.

    Third, as a general principle, it's always good to think in India from first principles. Good thinking on public policy in India often does this. This often leads to answers that are quite different from those seen in the West. Good examples in India include the equity market - in the early 1990s, the West was doing floor trading with mutual exchanges and India did different. With the currency and fixed income markets, RBI blindly copied the West and tried to transplant OTC trading when logic suggested otherwise - that was a clear opportunity to do better. With the New Pension System, pension reform in India fundamentally diverges from the mistakes of the West in setting up big population-wide defined benefit systems. And so on.

  4. Ajay,

    The US GDP currently is 70% consumerism, I do not want to encourage more consumerism now to risk a backlash later. I seriously doubt the real US GDP growth rate will be reflected for 2008-2009. Please look up
    for the real US GDP growth as -2% and decreasing still further. I think it is more trustworthy than Bureau of Economic Analysis (BEA). At least, India has not started lying to the same extent, though I wonder for how long it will last.

    I predict the real US GDP to take a conservative 20% (more like 30-40%) haircut in the next couple of years.

    Who would sell the bonds then? And most insiders know what the interest rate are going to be anyway. The 10 year period is probably because of the high interest rates, they will fall in a couple of years. Though I agree on the principle, practically it is useless.

  5. Amit,

    Read up on "Debt Management Office (DMO)" - e.g. the UK DMO. This is one of the simplest and best understood lessons of institutional architecture: the agency that sells government bonds must not be the agency that sets short-term interest rates. This is a conflict of interest.

  6. Ajay,

    That is interesting, I will read up on it.

  7. this is really a great will help a lot...


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