In the below video Dr. Nachiket Mor articulates the RBI committee‘s vision for financial inclusion and financial deepening in India covering aspects of Universal Electronic Bank Account, Payments, Credit, Priority Sector Lending and Customer Protection.
By Nachiket Mor
I was recently made aware of a fascinating speech2 on this topic given by Mr. V. K. Sharma (ED, RBI) in Mumbai on November 8th, 2012. In this speech he takes the example of three fixed income derivative contracts and examines why all three of them have failed to live up to their original expectations. He concludes his speech by making some important recommendations on what might be done to redress these failures.
He opens his remarks by commenting on the Interest Rate Swaps (IRS) market in which, “currently the 5 year IRS yield is trading at a negative spread of 120 basis points to 5 year G-Sec [Government of India Security]!” and as a consequence, “… while the G-Sec yield curve is almost flat, the IRS yield curve is steeply inverted…”. For fixed rate receivers, i.e., holders of government securities, he argues that this represents a very profitable and risk-less arbitrage opportunity “…involving buying corresponding maturity G-Sec in the cash market [therefore receiving fixed]3 by financing it in the overnight repo market4 [therefore paying the overnight repo rate], and paying fixed, and receiving overnight, in the IRS market!”. While it is not clear from the text of Mr. Sharma’s speech why, despite the existence of this enormous mispricing, the IRS market is so large (over Rs.50 trillion when the total G-Secs issued are only at Rs.30 trillion), he does express the concern that it represents a “veritable IRS ‘Super-Bubble’” and signifies a “massive ‘financial sector-real sector imbalance’”, created largely on account of, as I understood it, insufficient activity by arbitragers, in particular the public sector banks who have largely stayed out of the market5. This is certainly an interesting situation because it is the presence of arbitragers that is generally associated with existence of asset price bubbles and not the other way around.
In examining the Credit Default Swap6 (CDS) market, Mr. Sharma makes a similar point and argues that the massive mispricing in the IRS market made the CDS far too expensive to buyers and therefore the CDS market remained still-born and simply no arbitrage activity was even possible. He goes on to suggest that this is one of the reasons that the corporate bond market has itself not taken off because buyers of corporate bonds cannot purchase reasonably priced default protection. The Interest Rate Futures7 (IRF) in his view also suffered from insufficient arbitrage activity between the physicals market and the IRF market, allowing large levels of mispricing to persist.
He expresses the concern that in the absence of sufficient arbitrage activity not only have the derivative markets failed to evolve but their inability to transmit liquidity has led to continuing market fragmentation which in turn has been “…the biggest undoing of an efficient, deep, liquid, organically connected and seamlessly integrated financial market which is also a ‘sine qua non’ for effective, efficient, and instantaneous monetary transmission.”. In order to increase the level of arbitrage (and hedging) activity and to anchor the instruments and their prices to the real-sector in a manner that enhances liquidity and efficient price discovery in the physicals market, the following are a few of the recommendations that he makes8:
- Do not launch cash-settled IRF contracts because they will further increase the level of disconnection between the physicals and the futures markets.
- Do not permit IRF contracts that are just settled in the most liquid (and cheapest to deliver) G-Sec because it represents less than 10% of the physicals volume and will not therefore serve the liquidity transmission function.
- Removal of ‘hedge effectiveness’ criterion of 80% to 125% so that there is a great incentive to hedge even if the hedge is less than perfect9.
- Roll back the Held to Maturity (HTM) protection10 offered to banks. Given the very large size of the IRS market banks should easily be able to substitute this with hedges, particularly if they are allowed some leeway in computing effectiveness in accordance with the previous recommendation. This could particularly improve the participation of public sector banks in the fixed income derivative markets.
- Permitting delivery-based short-selling in the cash market and the introduction of term repo, and reverse repo, markets, both co-terminus with the tenure of futures contracts.
I found that the speech made very fascinating reading and offered important insights into why these markets have failed to take off and what might be done about it so that they can grow in an orderly manner.
- 1 – This blog post reflects my personal understanding of the speech given by Mr. Sharma and may not have accurately captured what he wanted to convey.
- 2 – Link to the full text of the speech: http://rbidocs.rbi.org.in/rdocs/Speeches/PDFs/SABF121112_F.pdf?cat_id=46&event_id=3
- 3 – Square brackets are mine.
- 4 – Overnight repo stands for Overnight “Repurchase Obligation” and represents the sale by the buyer of the G-Sec (or any other security) today for the agreement (or obligation) to repurchase it at an agreed upon price. The difference in the sale price and the agreed repurchase price represents the “repo rate”. For more detail see: http://en.wikipedia.org/wiki/Repurchase_agreement
- 5 – He reports that private banks constitute 18% of the market, foreign banks 80%, while public sector banks account only for 2% of the market despite controlling about 74% of the total assets of the banking system.
- 6 – A Credit Default Swap (CDS) is an agreement which refers to a specific Reference Bond and in which the buyer of the CDS makes to the seller a series of payments (comparable to a credit spread) and in return the seller agrees to compensate the buyer of the CDS, if the Reference Bond experiences a default. For more detail see: http://en.wikipedia.org/wiki/Credit_default_swap
- 7 – An Interest Rate Futures (IRF) contract is a futures contract in which the underlying asset is an interest bearing security or a basket of these securities chosen by the exchange on which the contract is listed in a manner consistent with regulatory guidelines. See the link for the RBI guideline on this: http://www.rbi.org.in/scripts/NotificationUser.aspx?Id=6912&Mode=0
- 8 – Full list and their exact wording are in the text of the original speech.
- 9 – Most accounting systems require all derivatives to be marked-to-market but do not generally require this for the underlying financial assets (“physicals”). This could result in substantial volatility in the profit-and-loss accounts of firms and financial institutions. In order to help mitigate this and better align accounting reality with the underlying economic reality, firms and financial institutions are permitted to net off “effective hedges” against the underlying.
- 10 – The HTM protection allows the banks to classify a host of securities as being intended to be held until they mature so that they then need not be marked to market. This protection often severely inhibits trading and hedging activity by banks.
There has been much discussion recently about the distorting nature of various indirect subsidies such as those being offered via price controls on fuel and fertiliser.
There is a case to include in this important debate the subsidies implied via financial sector policies, in particular, priority sector lending (PSL) requirements that guide the allocation of 40% of net bank credit (NBC). One of the significant bottlenecks to the growth of the Indian economy has been the small size of the financial sector.
The PSL requirement may then be viewed not necessarily as a subsidy but as a ‘policy nudge’ to bankers that amongst the various equally profitable opportunities that they are faced with, they should give higher priority to the PSL sectors, in larger national interest. Eventually, we need to increase the size of the financial sector and to complement banking sector resources with local debt capital markets as well so that all sectors can optimally absorb credit.
Above is an excerpt from an article published today in The Economic Times. To read the full article click here.
By Nachiket Mor
I recently had an opportunity to read an interesting book on farmer suicides in the Yavatmal district of Maharashtra by Secretary Health Meeta Rajiv Lochan1 (meeta29 [at] hotmail.com) and Professor Rajiv Lochan2 (mrajivlochan [at] hotmail.com). This book was first published in 2006 by the Yashwantrao Chavan Academy of Development Administration at Pune3.
The book was written in the aftermath of the spate of farmer suicides that were widely reported from Yavatmal district of Maharashtra during the five year period from 2000 to 2004. The book cites data from the State Crime Records Bureau of Maharashtra (SCRB) which shows that during this period the annual average for Yavatmal was 773 with between 25 to 30% of them being farmers. The authors point out that even though in terms of SMR (Suicide Mortality Rate = Suicides per 100,000 population) neither the District nor the State standout4, these numbers were considered highly unusual because they were directly comparable to the total for Mumbai (1100) while the population in the entire Yavatmal District at 2.45 million was only about a quarter of Mumbai’s population and because of the sharp rise over the last three decades in both the total number of suicides5 as well as the proportion of farmers (and housewives) impacted6. Since both the authors are very familiar with the manner in which government works, they were able to go the most appropriate sources for the data they needed. The book as a consequence has a good deal of carefully collected background information on whole issue of suicides as well as on Yavatmal which is well worth reading. For the book the authors interviewed the families of all of the farmer suicides that were reported by the local administration during the period January 1, 2001 to December 31st, 2005 – a total of 399 cases.
One of the principal lessons that they draw from their work is that: “It has been presumed until date that rural indebtedness is the root of all trouble. This postulate may not be entirely correct, as we shall see in the discussion that follows. Writing off rural debts is not, we submit the correct strategy to deal with the issue since debt was not the problem in the first instance.” The authors feel that seeing indebtedness as the cause is both convenient and stereotypical (the “rapacious moneylender”) which is why it is often the favoured choice. The authors also feel that the existing studies (they specifically refer to the ones carried out by TISS7and IGIDR8) did not adequately understand and analyse the data and the cases and quickly rushed to pronounce indebtedness caused by poor agricultural performance as the principal cause of distress leading to suicides9. The authors’ own examination of Yavatmal cases suggests to them that “even when debt existed it was factors other than debt, where were important for making the farmer a victim of suicide”.
From a study of the productivity patterns in Yavatmal they find that for cotton and for pulses (the other major cash crop for Yavatmal) the wide variation in annual productivity is not a recent phenomenon but exists right from the 1960s10, leading them to state that: “Might this suggest that production tribulations are part of the agricultural cycle and that change in it would, while affecting the finances of a farmer in the short run, not depress him enough to resort to suicide?”
After reviewing the existing studies they carefully examine each one of the 399 cases. They find that from a statistical point of view that neither caste nor marginal landholdings as a factor stand out thus suggesting to them that the data is not supportive of the popular view that marginalisation was a key factor. In terms of debt they find that about half the farmers had taken loans from informal sources and about three quarters from institutional sources11. They also found that only about a quarter had paid their institutional loans fully, 10% had paid partially, and about 40% had defaulted entirely. Of the 148 suicide cases that comprise the 40% they found that only in two cases that coercive action had been taken by the bank for the recovery of its dues. Others had received demand notices and were amongst the thousands to whom such demand notices were routinely sent12. Based on their analysis the authors state that: “How burdensome these demand notices were felt to be is anybody’s guess just as the issue of the seriousness with which a loan is repaid is an open question.” After examining all the cases for the various factors likely to be causing stress to the individual who committed suicide, the authors conclude that even where families were indebted it is not obvious that the financial stress was the principal trigger13. For example while studying cases of families that has large expenditures on healthcare, the authors conclude that, “In all these cases, families had large outstanding loans to pay out but there was also a large amount of social distress [unrelated to the debt] such that it is difficult to see that loans had much of a role to play in the tragedy that happened.”
Based on the extensive research that they carried out the authors conclude that there are two underlying problems that, in their opinion, seem to underpin all of the cases and appear consistent with the statistical data that they examined:
1. A very average low income of Rs.2500 per acre which was simply not enough to meet the requirements of farmer households. In their view it is the absence of adequate income rather than indebtedness that was at the root of most issues.
In order to address this, the authors favour direct cash transfers over other indirect subsidy mechanisms which have a serious risk of capture or being misdirected.
2. An extremely high level of isolation both from his / her fellow villagers as well as with the government machinery. Even in a popular movement like the SHG (self-help group) movement, while a few states have somewhat higher rates of participation, in Maharashtra participation in SHGs was as low as 5% at the household level. The authors were surprised to discover how few were the numbers of farmers (only 25%) that had any familiarity with concepts such as MSP (Minimum Support Price), or crop insurance. On this issue the authors conclude as follows: “Most farmers also did not belong to any formal registered body like a registered famers’ society or self-help group. Even fewer take any help or advice from these voluntary associations. Might this suggest the farmer to be a relatively lonely individual struggling against overwhelming odds? Without any help or back up support?”
In order to deal with this the authors strongly recommend that enhancing the frequency of “…physical interaction between government functionaries and village society by insisting on more tours, night halts, and gram sabhas by officers at all levels of the administration.
For those of us that are interested in the development of rural areas and have been particularly troubled by the whole suicide issue this book is a must read. The painstaking efforts by authors both to document each and every interview they have done as well as all of the statistical data they have gathered and presented, make this book also a very good reference book of a great deal of value to every library.
- The book was written when she was Director, Maharashtra State Institute of Rural Development.
- He is a Professor of Contemporary Indian History at the Lal Bahadur Shastri National Academy of Administration at Mussoorie
- “Farmer Suicides: Facts and Possible Policy Interventions”. The original book was published in 2006 but I referred to the 2010 Kindle Edition that was available from Amazon.
- The authors find that while Maharashtra has an SMR of 14, in Kerala it is 33, and in Japan it is as high as 40.
- From a total of 70 in 1975 to 613 in 2005 with SMR rising from 1.55 in 1962 to 9.34 in 2000.
- The authors find that the proportion of farmers and agricultural labourers rose steadily from a level of 18.57% in 1975 to 53.83% by 2005.
- Ajay Dandekar et al, “Causes of Farmer Suicides in Maharashtra: An Enquiry”, Tata Institute of Social Sciences, 2005.
- Srijit Mishra, “Suicides of Farmers in Maharashtra”, Indira Gandhi Institute of Development Research, 2005
- The authors find for example that in the TISS report a case on a loan of Rs.100,000 has been included in which the default had occurred 17 years prior to the date of the suicide and one on a loan of Rs.13,000 in which the default occurred 13 years ago.
- “In 1960-61, the earliest year for which we have data available [on the productivity for cotton], it was 103 kg/ha. Then it slumped to 47 in 1961-62, went up to 97 kg/ha in 1963-64, and went down to 63 kg / ha in 1966-67 and so on.”
- An interesting factor that they find is that: “Yavatmal has had a long history of interest rates of 25% [per season] (sawai) which are referred to as far back as the nineteenth century. In our study, we found that rates charged [by informal sources] varied from 3-5% per month to 25% per season (sawai) or 50% per season (dedhi)”. “A hundred years ago the district gazetteer said that the cultivators in Yavatmal district ‘almost always prefer to borrow from a money lender, paying perhaps twelve per cent interest, rather than from Government at six per cent. The chief reason seems to be that there is still great delay in getting money from the Government, or at least so the people think. It is also believed that certain subordinate servants of Government extract irregular fees while inquiries are made…” Is there a certain lesson in this for us even today?”
- The cooperative banks between them had send over 73,000 demand notices during the period from June 2004 to June 2005 and there were about 55,000 Revenue Recovery Cases of the District Central Cooperative Bank in the district.
- “Essentially what the empirical data shows is that the issue of rural indebtedness is a red herring. There is very little evidence of the pressure of loans being responsible for the suicide.”
As part of its “Microfinance Now” series that features interviews with leading figures in the world of microfinance, CGAP (Consultative Group to Assist the Poor) interviewed Nachiket Mor in its latest episode. Watch the video below: