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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.

1 comment:

  1. Could you please elaborate on why the BCD nexus can co-exist with lack of full capital account convertibility? The NDF market may not be active / liquid enough to hedge currency risks and access to onshore interest rate derivatives is also limited?


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