Tuesday, September 9, 2008

Problem Is not the Bond but its Segmented Market

Why did the RBI choose to create a special oil bond, forcing a segmentation of the bond market?

The answer, most likely, is that this was done to contain the fiscal deficit.
The huge oil subsidies are putting tremendous pressure on the government budget, imperiling the fiscal targets. Paying the subsidies by issuing bonds has the signal advantage that such spending is kept off budget. But it has the disadvantage of increasing the government's interest expenses. Expenses increase because the amount of government debt increases. Then, they could go up some more because the increase in government debt might lead to a rise in interest rates. It's a simple matter of supply and demand: the higher the supply of bonds, the lower the bond price -- which means the higher the interest rate.
"By making oil bonds a separate category, not eligible for the SLR, the RBI could preserve demand and supply in the regular bond market. Banks would ignore the oil bonds and bid aggressively for regular government bonds to meet their SLR requirements, thereby keeping interest rates low and keeping the government interest burden down.
But this "solution" created two new problems. First, it segmented the government bond market. There are now two completely different prices for government bonds, depending on whether they are SLR-eligible or not(sources: Economic Times)". This is a major impediment to market efficiency and development. For how can private firms price their bonds accurately, when even government bonds for similar maturities have two different prices?
The second problem is that the special oil bonds failed to solve the original problem. The oil companies still need cash.

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