The shrinking global government bond market
From 1965 to 1974, the OECD countries, as a group, had a sharp increase in the size of the State. The revenue and the expenditure of the State rose from around 26% of GDP in 1965 to around 31% of GDP in 1974. However, through this period, the public deficit stayed at modest levels of below 1% of GDP.
From 1974 onwards, there was a sharp retreat from fiscal prudence. Large fiscal deficits became the norm. The State continued to grow sharply, spending 42% of GDP in 1993. Revenues grew much more slowly, to reach 37% of GDP in 1993. For each year from 1974 to 1993, there was a large and prominent fiscal deficit.
This had a powerful side effect for financial markets. This steady issuance of public debt led to a huge expansion of market size of the government bond markets. Market size is a powerful determinant, along with market design, of market liquidity. The US bond market has had an extremely clumsy market design; however the sheer gigantic market size was effective in obtaining tremendous liquidity. As of today, the US bond market trades India's annual GDP in every two days.
The fixed income industry enjoyed enormous growth through these years. The US and Japanese yield curve became some of the most important objects in international finance. Fixed income derivatives blossomed, fueled by risk management needs of participants on these markets, and advances in financial economics and computation. Fixed income derivatives are substantially more complex than most traditional derivatives markets, since the underlying that fluctuates is the entire yield curve and not just one price. The classic research of Heath, Jarrow and Morton, which is considered by many to be "the Black and Scholes of fixed income" was done as recently as 1992.
The bestselling novelist, Tom Clancy, once said "the difference between reality and fiction is that fiction has to be plausible". The implausible reality is as follows. After 20 years of heady growth in size and sophistication, the writing is on the wall : government bond markets in OECD countries are dying.
What went wrong? The decisive factor that changed was a new capacity for fiscal prudence. For the first time in nearly 50 years, the deficit of OECD countries as a whole dropped to zero in 2000. In particular, there has been sharp fiscal adjustment in recent years. In 1993, expenditures were 42% of GDP and revenues were 37%, giving a fiscal deficit of 5%. In 2000, both were at 37.5%, giving a fiscal deficit of roughly 0.
Further, this overall average of zero masks a deficit of roughly 7% in Japan and surpluses in other countries. In countries such as the US, the government bond market is actually shrinking as surpluses are generating net buybacks of public debt. This is having an impact on bond market liquidity, particularly at the long-end of the yield curve. Currency forward and futures markets, which are priced off yield curves of both countries, will also suffer from greater illiquidity owing to fixed income illiquidity.
Is there a possibility of a retreat from fiscal prudence, once again, in coming years? This seems unlikely, given the extent of the intellectual consensus today in favour of a balanced budget and a small State. However, there is one key question which can undermine the fiscal stability of the OECD, which is pension reforms. With the exception of the UK, every OECD country faces an important vulnerability owing to ill-thought out pension programs (similar in design to India's EPS and civil servants pension programs). If these programs are not reformed, we will see the OECD going back into fiscal deficits within less than a decade.
The shrinking government bond markets have been of concern to everyone involved in the fixed income market in OECD countries. One interesting set of policy proposals, focused on the conduct of the debt management office, is found in Enhancing the liquidity of U.S. treasury securities in an era of surpluses, by Paul Bennett, Kenneth Garbade and John Kambhu, which appeared in the Economic Policy Review produced by the Federal Reserve Bank of New York in 2000.
Regardless of how debt management is done, private agents are increasingly using alternatives to US government bonds. The IMF's World Economic Outlook of May 2001 observes the paths being adopted:
- Bonds issued by para-statal entities, and by the safest of private corporations, are being used as proxies for US government bonds. Cash and repo markets in these securities have consequently become much more liquid.
- The drying up of liquidity in the 30 year US bond will have strong implications for portfolio managers, such as pension funds, who are used to hedging long-dated liabilities using long-dated US government bonds. They will need to learn to own short-dated US bonds and hedge away their consequent interest-rate exposure.
- Central banks are expanding the menu of securities they hold, away from a primary focus on US bonds.
Implications for global finance. The US yield curve is a public good for global finance. It gives the world a set of liquid, credible, riskless interest rates with a strong set of complementary liquid derivative products. The pervasive usefulness of the US yield is often inadequately appreciated. For example, one design of a financing package that I saw for a drinking water project in Tirapur (Tamil Nadu) was critically reliant on obtaining 30--year funds using the US yield curve.
It is likely that this free lunch will be diminished in the years to come: the US yield curve will be less liquid, and hence less credible. The derivatives market on the US yield curve will be less liquid and hence less useful. The global financial industry will seek alternative riskless yield curves and liquid derivatives markets, however there will be a loss (however small) in informational efficiency and access to liquidity.
Going beyond the yield curve, US bonds are an asset for holdings of foreign exchange reserves, and a safe haven for investors from all over the world seeking the riskless asset. These applications will increasingly need to migrate to alternative assets.
The Indian story. The bond market in India has grown tremendously in recent years, since we are blessed with large fiscal deficits. The growing market size has fueled liquidity, even though the basic policy stance of the RBI has not been oriented towards a transparent and liquid bond market, with sound foundations of clearing and settlement infrastructure. Optimistic scenarios for a fiscal adjustment in India involve bringing down the deficit to below 2% of GDP within five to ten years. Over this period, a large stock of government debt will be built up. This should exert a benign influence upon bond market liquidity and growth of the fixed income industry. Once the fiscal adjustment starts falling into place, we will see lower growth rates of the fixed income market through sheer growth in market size.
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