What's bizarre in Indian finance

When thinking about India's financial system, the ultimate focus should always be on market efficiency. The efficient market is the idealised state where prices incorporate information (and nothing but information). All financial products trade at their "fair" prices in the ideal efficient market, reflecting the tradeoff between risk and return. In the efficient market, well-diversified high risk portfolios earn greater average return than well-diversified low risk portfolios.

The five most egregious violations of market efficiency in India require no sophisticated analysis to detect. They are gross violations of any sane notion of the relationship between risk and return.

The interest rate on savings bank accounts versus the interest rate on government bonds. Normally, we would think that banks are riskier than the Government of India. The greater risk of banks should lead to a credit risk premium, whereby the interest rate that a bank has to pay is higher than the interest rate that the Government has to pay. But in India, it's upside down.

The interest rate on savings bank accounts versus the bonds that ICICI or IDBI issue. The rates of return which IDBI or ICICI have had to offer, in persuading people to buy their bonds, are remarkable. A back-of-the-envelope calculation reveals that if Bank of Maharashtra can borrow at 2%, and IDBI has to borrow at 12%, then the implied default probability of IDBI is around 9% if we assume that the insolvency probability of Bank of Maharashtra is zero. The implied default probability of IDBI would be higher if we assume reasonable values for the insolvency probability of Bank of Maharashtra.

Collateralised lending versus risky lending. Anywhere in the world, the interest rate in borrowing would have to be higher when there is less collateral. An adequately collateralised loan would have nearly-sovereign interest rates, and a loan with zero collateral would have to suffer the full credit risk premium for the borrower. In India, the call money market (and the inter-bank term money market) are based on zero collateral. The repo market is much safer since there is significant collateral. Yet, interest rates on the repo market are generally higher.

The variation in savings bank rate for weaker banks. A variety of statistics about bank vulnerability are widely known. The identities of the weakest 25 scheduled commercial banks in India are well known, and I expect that most of these will go into insolvency in the years to come. We would normally expect a credit risk premium associated with this: depositors should demand a higher interest rate when lending to a weaker bank. In India, this doesn't seem to happen. The weakest of banks offer interest rates much like the strongest banks, and even enjoy deposit growth while doing this.

The 12% number. Some financial products, e.g. the tax-saving scheme called PPF, offer a fixed 12% interest rate. This 12% is fixed in nominal terms. When the Government borrows at 12% (tax-free) on PPF, it is effectively paying 17% or so for those funds. At the same time, the Government is borrowing at much lower interest rates in primary issuance of government securities. This 12% number is fixed, whether interest rates or inflation changes. Indeed, we have seen this number fixed at 12% with inflation ranging from 3% to 12%, which implies a fluctuating real rate of return between 0% to 9%. Right now, with inflation near 3%, PPF is a 9% real rate of return: this is higher than even the equity rate of return of many countries. The grip of the 12% riskless nominal rate of return on India's financial system is nothing less than bizarre.

A central goal of a well functioning system of financial markets is to price risk appropriately, where activities which face greater risk are forced to pay a higher rate of return. The above examples are gross violations of this principle. If a space alien visited India, these would be the first "market inefficiencies" that he would notice. What is particularly striking about these inefficiencies is their importance in the economy. These inefficiences are not some obscure anomalies that some scholar has spent years in uncovering and documenting.

Each of these inefficiencies has its own "reasons" for existence. It is myopically efficient for many market participants to continue working with products and interest rates that they see around them. Yet, if we think about the economy as a whole, these five anomalies are the simple litmus tests of the sanity of India's financial system. Rapidly eliminating these anomalies should be an important goal in policy formulation.

To some extent, the seeds of change are already at hand. The rise of gilt funds and money market mutual funds is already presenting headaches for banks trying to charge inferior interest rates. Money market mutual funds are well placed to exploit the decline of banking, since they combine (a) access to the retail payments system (checks and ATMs), (b) higher rates of return as compared with banks, and (c) they are free of the concerns about bank insolvency, since the fiction of promising to return the deposit at a fixed and pre-determined interest rate is absent. Banking is criticised as a 19th century technology. MMMFs are the superior 20th century implementation of the same product.

If the RBI sets about building a well-designed `retail market for government securities', it could decisively shift interest rates on government paper to below the interest rates paid by banks.

The market design of India's fixed income market is riddled with mistakes. Yet, through a quirk of history, this is not a bottleneck for the corporate bond market. Corporate bonds trade on NSE's "Capital Market" segment, which is where equities trade. Hence, all the successful features of market design on the equity market are available when trading corporate bonds, except for one critical feature (depository settlement).

ICICI has commenced on a program of posting `limit orders' for its own bonds on the NSE, so that ICICI will always be there to buy or sell its own bonds on the NSE screen. When corporate bonds become fully dematerialised, it will become as painless to buy or sell corporate bonds as it is with the largest 104 equities in India (which are presently 100% in demat mode). Households who realise that buying and selling corporate bonds on any of the 2,200 NSE terminals is painless are likely to leave less money in savings bank accounts.

Deliberations on pension reform have already focused on moving away from the present structures of the PPF and EPFO, and should be accompanied by a complete elimination of the 12% number from all government products.

In summary, the five bizarre features of India's financial system listed above serve as a valuable and simple litmus test of the sanity of the risk/reward relationship that prevails. We don't need powerful financial econometrics to detect these failures of market efficiency. The elimination of each of these anomalies serves as a milestone for financial sector reforms.

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