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Emerging Markets Asia

17 August 2010

Top View | India


A primer on Indias fixed income market
The Indian fixed income market has developed rapidly since the structural changes made in the 1990s. These changes included technological and regulatory changes such as the electronic screen-based trading, the establishment of Clearing Corporation of India Ltd. (CCIL) and new instruments and initiatives to broaden the investor base. This primer provides a full spectrum of Indias fixed income market, describing the different market instruments and the roles, objectives and choice of instruments of the central bank, banks, nonbanks and foreign investors. A brief listing of settlement, pricing and taxation issues is also contained in this primer. Monetary Policy Framework - Policy decision making, policy targets, policy tools. Pages 2-5 Markets and instruments - Money market instruments, long-term instruments, derivatives. Pages 5-10 Supply - Issuers, issuance patterns. Pages 10-12 Demand - Primary dealers, banks, insurance companies, pension funds, FII, retail investors. Pages 12-14 Settlement, pricing and taxation. Pages 15-16 Conclusion. Page 16 List of tables Table 1: Cash instruments basic features. Page 9 Table 2: Derivative instruments basic features. Page 10 Table 3: Cash instruments supply and demand. Page 14 Table 4: Settlement and FII regulation and taxation. Page 16

Woon Khien Chia Emerging Markets Strategy +65 6518 5169 woonkhien.chia@rbs.com

Glossary. Pages 17-19 Appendix

Teck Wee Yeo Emerging Markets Strategy +65 6518 6160 teckwee.yeo@rbs.com www.rbsm.com/strategy - Lists of credit rating agencies, primary dealers, custodians and countries with double taxation avoidance agreement (DTAA). Pages 20-22

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Monetary Policy Framework


Emerging Markets Asia | 17 August 2010 2 The Reserve Bank of India (RBI) is the monetary authority, regulator and supervisor of the financial system, manager of foreign exchange, issuer of currency and a banker to the banks. In setting its monetary policy, the RBI balances growth and price and financial stability. The RBI uses a multiple-indicator approach to achieve its multiple objectives, monitoring the movements of interest rates, inflation rate, money supply, credit, exchange rate, capital flows along with trends in output. As the economy is heavily dependent on agriculture, weather factors such as monsoon sometimes influence the RBIs decisions, compelling the central bank to adopt both price and quantitative instruments for implementing the policy. Policy decision-making The process of monetary policy formulation has largely been an internal process. At the very apex of the policy process is the governor, assisted by a maximum of four deputy governors and guided by the Central Board of Directors (see below). The RBIs Monetary Policy Department (MPD) formulates the monetary policy in consultation with banks, insurance companies, pension funds and industry and trade associations. In parallel, a Technical Advisory Committee (TAC) reviews the macroeconomic conditions and advises the RBI. The final decision is solely that of the governor who seeks consensus from a 12-member (5 internal/ 7 external) Monetary Policy Committee (MPC) who sits on the board of directors. As announced at the 27 July 2010 policy meeting, monetary policy reviews are now conducted mid-quarter in addition to the quarterly reviews. The intention is to reduce the element of surprise to market participants from the inter-policy moves which have occurred quite often in the past. The central board of directors The Board is appointed by the government comprising 19 members divided into official and non-official directors. The official directors include the governor and the four deputy governors. The non-official directors include four directors nominated by the government to represent each local board, 10 directors nominated by the government possessing expertise in various segments of the economy and 1 representative of the central government. Policy targets Within its policy toolkit, the cash reserve ratio (CRR) and repo/reverse repo rates are the most commonly used tools by the RBI. Tools like Statutory Liquidity Ratio (SLR) and bank rate are used for long-term planning and are seldom adjusted. Repo/Reverse repo rates These are the rates used for the RBIs repo and reverse repo auctions with scheduled commercial banks and primary dealers under its Liquidity Adjustment Facility (LAF, see section below). Through the LAF, the RBI indirectly aims to keep the market overnight call rate within the corridor set by its targeted repo/ reverse repo rates. Oftentimes the market overnight call breaches this policy rate corridor due to a combination of reasons such as a shortage of eligible government securities among banks and dislocations in interbank credit risks. The current repo rate is at 5.75 % while the reverse repo rate is at 4.5% giving a spread of 125 bps. On a hiking cycle, the operational or effective policy rate is the repo rate as the interbank market as a whole would be generally short of

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Bank rate Bank rate is the rate at which the RBI is ready to either buy back or rediscount bills of exchange or other commercial papers with banks. The bank rate is used to signal the medium to long-term stance of monetary policy. The rate has not changed since April 2003 and currently stands at 6%.

Figure 1: RBIs targets on reverse repo rate, repo rate and bank rate (%)
10 9 8 7 6 5 4

Figure 2: RBIs policy tools CRR and SLR (%)

28

23

18

13

3 2 Mar-04
3 Jan-04 CRR

Mar-05

Mar-06 Repo

Mar-07

Mar-08

Mar-09

Mar-10

Jan-05 SLR

Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

Reverse Repo

Bank Rate

Source: RBI

Source: RBI

Policy tools Cash reserve ratio (CRR) The RBI requires banks to maintain a fraction of their net demand and time liabilities (NDTL) in the form of cash with the central bank so that they have sufficient cash to cover customer withdrawals. The ratio is applied to Scheduled Commercial Banks (SCB) but excludes regional rural banks. Under it the RBI Act, the RBI can raise CRR to a maximum of 20% and a minimum of 3% of NDTL. CRR reached a peak of 9 % in July 2008 before it was brought down sharply to 5% after the breakout of the global credit crisis in 2008/09. Currently, the CRR stands at 6% (see Figure 2). Statutory liquidity ratio (SLR) The SLR is the percentage a commercial bank needs to maintain in the form of cash, gold or government approved securities against its total credit outstanding. As borrowing from the open market forms a critical part of the governments financing over the years, this tool has become an important support for the governments fiscal financing programme.

Emerging Markets Asia | 17 August 2010

liquidity and would need to be net borrowing from the RBI at the repo rate. Vice versa, on an easing cycle, the operational rate is the reverse repo rate. At the beginning of a turning point in the policy cycle, the RBI tends to maintain a tighter policy rate corridor so as to guide the market towards the desired operational rate while towards the end of a policy cycle, it tends to broaden the policy rate corridor to provide the scope for the market to trade away from the operational rate towards the other rate. Over the past ten years, the spread has varied from 100bp to 700bp averaging around 175bp (see Figure 1).

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Bonds which are eligible for SLR include the central and local government securities, T-bills and cash management bills. All other bonds are not eligible for SLR, including Public Sector Undertaking (PSU) bonds, corporate bonds and Government securities issued for special purposes like Oil Bonds, Food Bonds, Fertilizer Bonds, etc. Liquidity adjustment facility (LAF) This is a facility extended by the RBI to allow banks to park their funds with the central bank in case of an excess or borrow from it in case of a shortage. It is done on an overnight basis against the collateral of eligible securities, including all the SLR-eligible securities as well as selected government securities issued for special purposes. Repo auction operations facilitate liquidity injection whereas reverse repo auctions are used to absorb the liquidity (see Figure 3). Open market operations (OMO) In addition to LAF, the RBI also makes outright sale and purchase of government securities in the market. RBI soaks the liquidity from the market by selling government securities and vice versa it injects liquidity into the system by buying securities from the market. However, more often than not, he RBI uses the window to smooth out fluctuations in the bond market rather than to manage liquidity. Market stabilization scheme (MSS) The MSS was introduced in 2004 to absorb the surplus cash generated due to the central banks dollar buying intervention in the FX market. It is thus essentially an FX sterilization tool. Under the MSS, the government issues treasury bills and/or dated securities on top of its normal fiscal borrowing requirements for absorbing the excess liquidity from the market which resulted from the RBIs FX intervention. These securities are issued and serviced like existing bills and dated securities by way of the RBIs weekly auction. The amount raised under MSS is held in a separate cash account which is maintained and operated by the RBI. This amount is appropriated only for the purpose of redemption or to buy back treasury bills and dated securities issued under this scheme. Payments for interest and discount are not made from the MSS account and the receipts due to premium and/or accrued interest are not credited to the MSS account. Such payments or receipts are dealt through the governments account with the RBI. During the 2008/09 global credit crisis, the government held back from issuing MSS bonds to allow outstanding MSS bonds to roll off and release liquidity back into the market to support the governments fiscal stimulus spending. In addition, the RBI also de-sequestered some MSS bonds to the governments account. As a result of these actions, MSS balances came down from INR1.7trn in March 2008 to INR880bn in March 2009 and further to INR27.4bn by March 2010. As at June 2010, the MSS balance stood at INR3.17bn (see Figure 4). After the global credit crunch subsided, the RBI has restarted issuing MSS bonds, with a INR500bn limit set for FY2010/11 which is substantially lower than the INR2.5trn limit for FY2007/08.

Emerging Markets Asia | 17 August 2010

SLR has remained at 25 % since November 1997 except at the peak of the 2008/09 crisis period when it was reduced to 24% for a year from November 2008 to November 2009. The ratio can be increased to a maximum of 40%.

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Refinance facilities The RBI provides refinance facilities to banks for lending to specific sectors, with the most important being the export sector. All scheduled banks which are authorized dealers in foreign exchange and have extended export credit are eligible to avail of the export credit refinance facility. The government increases the ceiling for these loan facilities when it wishes to pump in liquidity to specific sectors. The refinance facility is available at the RBIs repo rate and is allocated in multiples of hundred thousand rupees. As at April 2010, the RBI has INR99.38bn in export credit refinance facility.

Figure 3: Net reverse repo outstanding under LAF* (INR trn)


2 .0 1 .5 1 .0 0 .5 0 .0 -0 .5 -1 .0 -1 .5 Ja n Jul Ja n Jul Ja n Jul Ja n Jul Ja n Jul Ja n Jul Ja n Jul 04 04 05 05 06 06 07 07 08 08 09 09 10 10

Figure 4: MSS bonds outstanding (INR trn)

2 .0 1 .8 1 .6 1 .4 1 .2 1 .0 0 .8 0 .6 0 .4 0 .2 0 .0 Ja n Jul Ja n Jul Ja n Jul Ja n Jul Ja n Jul Ja n Jul Ja n 04 04 05 05 06 06 07 07 08 08 09 09 10

* negative refers to liquidity withdrawal. Source: Bloomberg, RBS

Source: CEIC, RBS

Markets and instruments


The Indian fixed income market is one of the most actively traded markets in Asia with its size and depth comparable to those of the developed markets. As is the case with the developed world, the Indian fixed income market is also dominated by the government securities, commonly known as GSecs or gilts. The GSec market is characterized by an efficient auction process and a liquid secondary market. Areas for future development would be to deepen the retail investor base on the demand side and the corporate bond market on the supply side. Money market instruments (reference Table 1, page 9) Treasury bills (T-Bills) Treasury bills are short-term debt instruments issued by the RBI on behalf of the government. They are issued as discount (zero coupons) securities in three tenors namely, 91 days, 182 days and 364 days. The RBI conducts T-bill auctions every Wednesday. Call money/ notice money/ term money Call money market is a market for uncollateralized lending and borrowing of funds. This market is predominantly overnight and is open for participation only to scheduled commercial banks and primary dealers. If the money lent exceeds 5

Emerging Markets Asia | 17 August 2010

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one day but is less than 15 days, it is called notice money market. If it exceeds 15 days but doesnt exceed 1 year, it is referred to as term money market. Repo In addition to engaging in repo transactions with the RBI under LAF, interbank market participants also engage in repos among themselves. The daily turnover of the interbank market repo is generally higher than the call market but lower than LAF. The list of eligible collaterals for market repos are more wide-ranging than that for LAF, including GSecs, T-bills, special securities and state development loans (SDL). As of 1 March 2010, even corporate bonds rated AA or above can be used for repo borrowing with an initial margin of 25%. Predominantly, the repos are undertaken on an overnight basis although there is no restriction on term repos. Certificates of deposit (CD) Certificates of deposits are the certificates issued by banks and financial institutions. The tenor ranges from 7 days to 1 year for banks and from 1 year to 3 years for financial institutions. Commercial paper (CP) Commercial paper is issued in the form of a promissory note which is essentially an unsecured money market instrument. Corporate, primary dealers and all financial institutions are permitted to issue them to raise short-term financing of funds under an umbrella limit set by the RBI. Main investors are banks, insurance companies and mutual funds. Mandatory credit rating by an RBI approved credit rating agency has to be attained by the issuer for its commercial paper. Maturities of CPs can range from 7 days to 1 year. Collateralized borrowing and lending obligation (CBLO) This money market instrument is operated by the Clearing Corporation of India Limited (CCIL) for the benefit of entities which have no access to interbank call money market or have restricted access in terms of ceiling on call borrowing and lending. Securities eligible as collateral can be GSecs or securities specified by the CCIL. It is available in electronic book entry form as a discounted instrument with maturities ranging from 1 day to 1 year. In terms of turnover volume, CBLOs are the most traded money market instrument behind RBIs LAF. Cash management bills (CMB) In August 2009, the government decided to introduce a new short-term instrument known as cash management bills to meet its temporary cash flow mismatches. These bills are non-standardized and the tenor which can be no more than 91 days, amount and date of issue depend on the temporary cash requirement of the government. The bills are sold at a discount. The announcement of the auction is made by the RBI one day prior to the auction. Thus far, the government has auctioned CMB twice, once on 11 May 2010 and a second time on 18 May 2010 for a notified amount of INR60bn with the same maturity date on 16 June 2010. Long-term securities Dated government securities (GSecs) Emerging Markets Asia | 17 August 2010 6

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Figure 5: 10y GSec yield vs. WPI YoY (%)

Figure 6: 10y GSec yield vs. 10y UST yield (%)

1 4 1 2 1 0 8 6 4 2 0 -2 Jan 01 Jan 02 Jan 03 Jan 04 Jan 05 Jan 06 Jan 07 Jan 08 Jan 09 Jan 1 0

1 2 1 0 8 6 4 2 0 Jan 01 Jan 02 Jan 03 Jan 04 Jan 05 Jan 06 Jan 07 Jan 08 Jan 09 Jan 1 0

2y Gsec

WP I (yo y)

1 Gsec 0y

1 UST 0y

Source: Bloomberg, RBS

Source: Bloomberg, RBS

Special securities The government issues special securities to companies like oil marketing companies, fertilizer companies, the Food Corporation of India as compensation in lieu of cash subsidies. These are usually long-dated bonds about 20-25 basis points higher than regular GSecs of similar maturity to compensate for the illiquidity. As the companies given these special GSecs are usually state-owned (e.g. oil bonds are given to Indian Oil Corp), these bonds can be kept off the governments budget. The government pays out approximately INR100bn a year as interest payments on oil bonds alone. Since 2005, the government has issued special securities mainly to oil and fertilizer companies apart from a small handful of issues to the Food Corporation of India, a state bank and a non-bank FI. A conscious effort is now being made to avoid issuing new oil and fertilizer bonds so that the government now extends its subsidy in cash thereby bringing all subsidy-related liabilities onto the balance sheet for fiscal accounting. Except for interest payments and redemption for FY 2008/09, no new oil and fertilizer bonds were issued in FY 2009/10. Special securities are not SLR-eligible but some are selectively eligible as collateral under LAF. Capital Indexed Bonds The principal of these bonds are linked to an accepted index of inflation with a view to protecting the holder from inflation. One variant of capital indexed bonds was issued in December 1997 linked to the wholesale price index. It was not too successful as it offered inflation hedging only against the principal while the 7

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Dated government securities are issued by the government to finance its fiscal deficit or infrastructure development programmes. These are long-term securities, with maturities ranging from 2 years to 30 years. The yields are driven by factors such as policy rates, domestic inflation and sometimes follow the direction of the US treasuries (see Figures 5 and 6).

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Bonds with call/put options GSecs with put/call options up to a maturity of 10 years were issued on 18 July 2002. The optionality on the bond could be exercised after the completion of five years from the date of issuance on any coupon date thereafter. Out of the INR30bn issued then, INR 5.5bn worth of bonds are currently still outstanding. Separate trading for registered interest and principal of securities (STRIPS) The guidelines for stripping/reconstitution of the securities came into effect on 1 April 2010, allowing participants to strip/reconstitute eligible GSecs through the Negotiated Dealing System (NDS) subject to terms and conditions. STRIPS are tradable only in the OTC market and is reported to the NDS for clearing and settlement through the CCIL. STRIPS give rise to sovereign zero coupon bonds which will gradually lead to the development of a market-determined zero coupon yield curve. As STRIPS do not have any reinvestment risk, they can be attractive to retail/non-institutional investor. State development loans (SDL) State governments issue dated securities called State Development Loans (SDL) to directly raise funds from the market. Generally the yields on SDLs are slightly higher than the yields on GSecs of similar maturities. They are eligible for SLR and for borrowing from the RBI through repo under LAF. Public sector undertaking (PSU) bonds Public sector undertaking (PSU) bonds are medium to long-term bonds issued by public sector organizations (e.g. State Electricity boards, improvement trusts, metropolitan authorities etc). Some of the bonds are guaranteed by the central or state government. Typical maturities for PSU bonds are 3-10 years. These bonds might carry a call/put option. Corporate bonds A well developed corporate bond market may enable the corporates to tap the market for their financial needs thereby reducing the systemic stress on banks. The RBI has every now and then initiated measures to develop the corporate bond market, which as of now stands barely a fraction of the government bond market. Nevertheless, there has been a significant growth in the secondary market activity for the corporate bond markets. Corporate bonds tend to have a maturity of up to 20 years and often come with call or put options and sometimes in the form of convertibles.

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coupons were unprotected. Steps are now being taken to come up with new capital indexed bonds which have both the coupon and principal linked to the wholesale price index.

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Table 1 : Cash instruments basic features


Issuer(s) Treasury Bills Cash Management Bills GSecs State Govt Loans Commercial Paper Certificates of Deposit Corporate Bonds PSU bonds Special Securities Central government Central government Tenor(s) 91,182 and 364 days Up to 91 days Coupon Zero. Discounted Instrument Zero. Discounted Instrument Day Count Actual/365 Actual/365 LAF Eligible Yes Yes SLR eligible Yes Yes

Central government State governments Indian companies, supranaturals Banks and financial institutions Public limited companies Public sector organisations Central government

2-30 years 2-15 years 7 days -1 year 7 days-1 year 1-20 years 1-15years 1-20years

Mostly fixed, with semi annual payments Mostly fixed with semi annual payments Zero. Discounted Instrument Zero. Discounted Instrument Mostly fixed. Annual or specific issuance Mostly fixed with semi annual payments Mostly fixed with semi annual payments

30/360 30/360 Actual/365 Actual/365 Actual/365 Actual/365 30/360

Yes Yes No No No No Yes selectively

Yes Yes No No No No No

Source: RBI, Bloomberg, RBS

Derivatives (reference Table 2, page 10) Interest rate swaps (IRS) In the INR swap market, several alternative floating rate benchmarks have evolved over time, among which the most commonly traded one is the OIS. One main reason for the innovation of the different floating rate benchmarks is because of the ban on the use of optionality in interest rate swaps. - Overnight Index Swaps (OIS) The floating benchmark used is the overnight call money rate, MIBOR, which is a daily fixing set by the national stock exchange using inputs provided by the market makers. The market is highly liquid up to the 5-year tenor. - MIFOR Swaps The floating rate in this case is the implied INR offer rate derived from USD/INR FX forward exchange rate. A large number of Indian corporates regularly use MIFOR to manage their interest rate risk. - Swaps with floating rates linked to GSec yields - These swaps allow banks and corporates to take views on the relative movements of GSec yields and corporate spreads without any underlying positions in the securities. Currency swaps These are interest rate derivatives where the INR payments can be swapped into another currency or vice versa. USD and JPY are the two most common second currencies for a currency swap in INR. Interest rate futures Interest rate futures were re-launched in 2009 by the RBI. An earlier edition launched in 2003 failed due to faulty benchmarks and the fact that the futures could only be used for hedging and not for trading. New contracts on 10y notional coupon-bearing GSecs were issued in August 2009, with a notional coupon of 7% per annum with semi-annual compounding. A proposal is underway to introduce interest rate futures on 5y and 2y notional coupon-bearing securities and 91-day treasury bills.

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Table 2: Derivative instruments basic features


Tenors Onshore OIS 2m-10y (liquid 1y-5y) Liquidity 10-30bp for <1y 2-4bp up to 1y 5-15bp for >5y 3-4bp up to 5y 5-10bp for >5y 30bp up to 5y 30-50bp for >5y 30bp 20bps Day Count Actual/365 Fixing Rate Overnight rate Effective Date T+1 Participants Interbank, corporates Interbank, corporates Interbank, corporates Interbank, corporates Interbank, corporates Non-resident access Not allowed

Offshore NDIRS MIFOR Swaps Onshore CCS Offshore CCS

1y-10y (liquid up to 5y) 1y-10y (liquid up to 5y) 1m-10y (liquid up to 5y) 1m-10y (liquid up to 5y)

Actual/365 Actual/365 Actual/360 Actual/360

Overnight rate 6m implied USD/INR swap offer rate 6m mifor 6m libor

T+1 T+1 T+2 T+2

Allowed Not allowed Principal hedging allowed Allowed Source: FIMMDA, RBS

Credit Default Swap (CDS) The RBI has drafted rules proposing the introduction of plain vanilla over-thecounter single-name CDS for corporate bonds. Infrastructure bonds will be the first bonds which can be hedged using CDS. The plan of launching CDS has been deferred twice in the past in 2003 and 2007. No timeline has been set yet for the latest proposal.

Supply
Apart from the central and local governments, banks and financial institutions are the next biggest group of bond issuers in the market (see Figure 7). As said, corporate issuance has not been keeping apace with the average market growth over the years. The average issue size of corporate bonds is also the smallest in the market at INR1bn compared to the average GSec issue size of INR150bn. By maturity, the GSec market offers the longest maturity up to 30 years while corporate bonds have tenors stretching into 20y. The maturity profile of the GSec market is bunched up heavily in the 4y to 8y segment (see Figure 8). Table 3 on page 14 lists the supply and demand picture by instruments and primary and secondary market participants.

Figure 7: Market share of bonds listed on NSE by instrument type/ issuer (INR trn)
35

Figure 8: Maturity profile of outstanding GSecs (INR bn)

2.0

30 25 20 1 5 1 0 5 0 Jan 05 Jul 05 Jan Jul 06 06 SDL Jan Jul 07 07 FI&banks Jan 08 Jul 08 Jan Jul 09 09 Jan 1 0

1.8 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 Tenor remaining GSec T-bill Special securities

Gsec&Tbills

P SU, supras

Co rpo rate

Source: CEIC, RBS

Source: Bloomberg, RBS

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Issuers Central government For FY 2010/11, the government has set a target fiscal deficit of 5.5% of GDP or close to INR 3.8trn. To finance approximately 90% of this deficit, the government has set a borrowing program targeting net INR3.45trn to be raised mostly through the issuance of new GSecs. The tentative targets for fiscal deficit are set at 4.8% and 4.1% of GDP for FY 2011/12 and 2012/13 respectively. In the 12 five-year plan, the government has set a target of USD1trn for infrastructure spending and will allow private companies to issue infrastructure bonds. State governments State governments fund their budget through both transfers from the central government and issuing their own bonds, known as state development loans (SDL). In FY2009/10, state governments in total raised INR1.3trn of SDLs. This compares to INR4.2trn of GSecs and INR3.8trn of T-bills issued in the same year. Corporates Corporate bonds include bonds issued by PSUs, banks and private sector companies, with PSU bonds holding the largest share. One reason for corporates preference to rely on bank borrowing to raise funds rather than issuing bonds is that they have to get a credit rating to determine the premium of their bonds over GSecs. Issuance patterns GSecs The RBI announces the half-yearly auction calendar of GSecs in March and September each year. Usually, close to 60% of the annual fiscal borrowing is completed in the first half of the year. There are 15 to 18 benchmarks on the GSec curve, depending on how many issues qualified as benchmarks at any point in time. On average, each benchmark issue stays on the benchmark curve for about a year except for the 5y and 10y tenors which sometimes get revised more than once a year. Changes are decided by the Fixed Income Money Market and Derivatives Association of India (FIMMDA) based on size, trading volume and market consensus during its meeting towards the end of each month. Observing that the government usually stops tapping into a particular issue when its outstanding size gets too large to avoid bunching its liability into a single maturity date, the FIMMDA replaces a benchmark when it gets close to the governments undisclosed ceiling, observed to be around INR650bn. The issue with the highest trading volume close to the outgoing benchmark is usually selected as the new benchmark. A new issue by the government thus does not automatically come in as a new benchmark. T-bills Treasury bills are auctioned on every Wednesday. 91-day bills are issued every Wednesday while 182-day and 364-day bills are issued on alternate Wednesdays. 364-day bills are auctioned on the Wednesday preceding the Friday when the banks are required to report their reserve requirements to the RBI. 182-day bills are auctioned prior to non-reporting Fridays. The settlements for the T-bills are made on the following Friday. Emerging Markets Asia | 17 August 2010 11

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State development loans (SDL) SDLs are issued through an auction similar to that for GSecs i.e. multiple-price competitive bidding and typically, 5 to 6 state bonds are being auctioned together. There are usually 6 to 8 auctions conducted a year. Quasi-government/ Corporates PSU bonds are privately placed with the major investors, being banks, insurance companies, mutual funds, financial institutions, state-run pension funds and cash-rich corporates. Other corporate bonds are usually sold through a bookbuilding process. Special securities Special securities are directly issued to corporates or state agencies to subsidise their operations. There is therefore no open market auction. The number of issues also varies from year to year and as aforesaid, the government is gradually phasing out the issuance of special securities.

Demand
The major investors of the GSec market include banks, pension funds and insurance companies, with banks accounting for just below 70% of the total market (see Figure 9). Most GSec investors are fairly stable investors including even foreign institutional investors which have gradually shifted their asset allocations from equity into debt from less than 1% a decade ago to nearly 15% now (Figure 10). Mutual funds are by comparison relatively volatile. Quite understandably, the RBIs GSec holdings are also fairly unstable given its conduct of daily open market operations and having entered into quantitative easing (QE) during 2007/08 to help ease the governments then fiscal funding pressure.

Figure 9: GSec holdings by banks, mutual funds, FII and RBI (INR trn)
1 6 1 4 1 2 1 0 8 6 4 2 0 00 01 02 03 04 05 06 07 08 09 1 0 0.0 -0.5 1 .5 2.5 2.0

Figure 10: Cumulative net FII flows into debt vs. equity (USD bn)
1 6 1 4 1 2 1 0 90 80 70 60 50 8 40 6 4 2 0 98 99 00 01 02 03 04 equity (RHS) 05 06 07 08 09 1 0 30 20 1 0 0

1 .0 0.5

B anks RB I (RHS)

M utual funds (RHS) FII (RHS) debt (LHS)

Source: CEIC, RBS

Source: CEIC, SEBI, RBS

Primary Dealers (PD) Primary dealers are either banks (presently 12 of them, see list in Appendix) or specialized financial firms (presently 8). For auctions, bids are invited from PDs 12

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- Minimum underwriting commitment (MUC) per PD: This is computed in a way that ensures that at least 50% of each issue is covered by the aggregate of all MUCs. Each PD has a uniform MUC irrespective of the size of its balance sheet or capital. - Additional competitive underwriting (ACU) per PD: The remaining portion of the notified amount is opened to competitive underwriting through underwriting auctions. Each PD is required to bid for a minimum of 3%. The auction could be uniform price based or multiple price-based. PDs do not have to underwrite fully subscribed issues unless they want to bid. If there is a devolvement, the successful bids put in by the PDs are set off against the amount underwritten by them when deciding the amount of devolvement. Banks The banking sector is the single largest subscriber of Gsecs largely as a result of having to fulfil the statutory liquidity ratio. Scheduled Urban Co-operative banks (UCB) are supposed to hold 25% of their SLR requirement in Government and approved securities (Gsecs, T-bills and SDL). Non-scheduled urban cooperative banks with NDTL more than INR250mn have to hold 15% of their SLR requirement in government approved securities. Those with less than INR100mn NDTL have to hold 10% of their SLR requirement Regional rural banks are supposed to maintain their entire SLR requirement (which is 25% of NDTL) in GSecs and other approved securities. Rural cooperative banks can maintain their SLR requirement in cash, gold or approved securities. Non-government provident funds, superannuation funds and gratuity funds are required to invest 40% of their incremental accretions in central and state government securities. Insurance companies and pension funds The other key bond investors are pension funds, insurance companies and mutual funds. Life insurance companies tend to hold a large amount of GSecs, the largest one being the Life Insurance Corporation. Among pension funds, the largest investor in GSecs is the Employee Provident Fund. Life insurance companies and pension funds tend to hold close to 50% and 25 % of their liabilities against GSecs. Insurance companies, provident funds and banks have restrictions on private sector securities and hence the demand for the corporate bonds is low. Even if they do purchase corporate bonds, their tendency to hold them to maturity will only further reduce the trading volume of these bonds. Funds are allowed to invest only up to 10% into corporate bonds and up to 40% in PSU bonds. Foreign Institutional Investors (FII) The key restriction on foreign institutional investors (FII) is in the form on aggregate ceilings on how much they can hold in the GSecs and corporate bond markets. An earlier restriction on a 70:30 investment ratio between equity and debt was removed in 2008. In the same year, the ceiling for investments in GSecs was lifted from USD3.2bn to USD5bn. In March 2009, the FII ceiling for investments in corporate bonds was lifted from USD6bn to USD15bn. There are currently talks about further increasing the ceilings.

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one day before the GSec auction wherein the PDs indicate the amount to be underwritten by them and the underwriting fees. PDs have to meet two commitments for underwriting.

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For a list of FAQs on FII investments, please see the following SEBIs website link: http://investor.sebi.gov.in/faq/foreign%20institutional%20investor.html. Not to be confused with the FII limits, there is another limit set by the RBI on local corporates external commercial borrowings (ECB) to restrict their overseas borrowing. To promote the countrys infrastructure development plans, rules governing prior approvals and spreads over USD Libor have been relaxed for infrastructure firms in 2008. Retail Investors Retail investors have very low participation but over the past few years, they have gradually increased their participation in mutual funds and bond funds. To enable small and medium-sized retail investors to participate in the auction process, the RBI has introduced non-competitive bidding in GSecs.

Table 3: Cash instruments supply and demand


Issuer Auction Style Average Auction Size (number of issues outstanding) 10-80bn (51) 60bn (0) 20-60bn (96) 20-60bn (1342) 1-2bn Outstanding Amount (as at Jun 2010) Issuance Cycle Primary Market Participants Secondary Market Participants

Treasury Bills

Central government

Multiple Price

1.3trn

Cash Mgmt Bills (CMB) GSecs

Central government

Multiple Price

91d every Wednesday 182d-364d alternate Wednesday Ad hoc

Institutions, banks, mutual funds Institutions, banks, mutual funds Institutions, banks, mutual funds Institutions, banks

Central government

Multiple Price

20.2trn

2-4 auctions per month

State Govt Loans (SDL) Commercial Paper (CP) Certificates of Deposit (CD) Corporate Bonds PSU

State governments

Multiple Price

5.55trn

6-8 auctions per year

Indian companies, supranaturals Banks

Bilateral Issuance

1trn

Ad hoc

Institutions, banks, mutual funds Institutions, banks, mutual funds Institutions, banks, corporates, mutual funds Institutions, banks, mutual funds

Bilateral Issuance

1-2bn

3.2trn

Ad hoc

Public listed companies Public sector organisations

Mainly bookbuilding Private placement

1-2bn (1049) 3-5bn for tenors <=5y 1-2bn for tenors >=10y (850) INR10-200bn (31)

1.46trn

Ad hoc

1.78trn

Ad hoc

Fund managers, insurance companies, banks Fund managers, insurance companies, banks Fund managers, insurance companies, banks Fund managers, insurance companies, banks Fund managers, insurance companies, banks Fund managers, insurance companies, banks Fund managers, insurance companies, banks Fund managers, insurance companies, banks

Special securities

Central government

Bilateral placement

2trn

Ad hoc

Corporations receiving subsidies in strategic sectors including oil, food & fertilizer or for bank recapitalisation

Insurance companies, fund managers

Source: Bloomberg, RBI, RBS

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Registered FIIs are eligible to invest in all securities issued by the central and state governments as well as quasi-government entities as long as the organisation is more than 51% owned by the central or a state government. They are also allowed to invest in corporate bonds or debentures as long as they are listed in the national stock exchange. FIIs are not permitted to invest in certificates of deposit. FIIs have recently become a driving force in the secondary market for corporate bonds, accounting for almost half of the overall volumes in the first four months of 2010. Their ceiling for the GSec market has also been hit.

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Settlement, Pricing and Taxation


Emerging Markets Asia | 17 August 2010 15 (Reference Table 4, page 16) Settlement Government securities GSecs are held in security accounts maintained by interbank counterparties with the RBI. All the deals are settled through CCIL using the DvP (Delivery vs. Payment) mechanism. This mechanism ensures that on settlement date, transfer of securities by the seller occurs simultaneously with transfer of funds from the buyer. In the secondary market, CCIL guarantees settlement of trades on the settlement date by becoming a central counter-party to every trade. All outright secondary market transactions in GSecs are settled on T+1 basis. However, in case of repo transactions in GSecs, market participants have the choice of settling the first leg on T+0 basis or T+1 basis while the second leg has to be settled on a T+1 basis. Corporate securities As decided by SEBI in 2009, all trades in corporate bonds between mutual funds, foreign institutional investors or their sub-accounts, venture capital funds, foreign venture capital investors, portfolio managers and RBI-regulated entities are cleared and settled through the NSSCL (National Securities Clearing Corporation Limited) or the Indian Clearing Corporation Limited (ICCL). This is applicable to all corporate bonds traded after 1 December 2009 on OTC or on the debt segment of the stock exchange. This arrangement facilitates the settlement of secondary market trades on corporate bonds on a DvP basis. Pricing Sources Negotiated Dealing system (NDS) The price and other information of a trade are stored under NDS on the RBI website or on the CCIL website through NDS Order matching (NDS-OM).Since NDS-OM is a live and anonymous platform where the trades are disseminated as they are struck and where counterparties to the trades are not revealed, NDSOM is the safest and most transparent pricing source. Transactions undertaken between market participants in the OTC market or through the telephone are expected to be reported on the NDS platform within 15 minutes after the deals are put through. All OTC trades are required to be reported on the secondary market module of the NDS for settlement. Fixed Income Money Market and Derivatives Association of India (FIMMDA) FIMMDA is also a source of price information, especially for securities that are not traded frequently. FIMMDA releases rates of various GSec issues that are used by market participants for valuation purposes. For benchmark, liquid securities, the prices are polled from various active market participants between 3pm and 4pm every working day. The collected data gets automatically transferred to Bloombergs valuation system for generating the prices of all outstanding securities. For the illiquid securities, the various market participants are polled for different illiquidity premiums on different maturity buckets. These illiquidity premiums are then added to the liquid yield curve and an illiquid yield curve is established by

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Taxation Currently the interest income tax on FIIs is 20% subject to double taxation agreement (DTA) whereas the capital gains tax is 30% and 10% for short-term and long-term respectively. The capital gains tax is also subject to double tax agreement. India has entered into a Double Taxation Avoidance Agreement (DTAA) with numerous countries (see Appendix). If the capital asset is held for more than 36 months prior to its transfer, the gains are long term gains. However, the qualifying period of holding is 12 months in the case of GSecs and listed corporate bonds. The government is the midst of streamlining the tax rates for all holding periods of bonds by FIIs.

Table 4: Settlement and FII Regulation and Taxation


Settlement primary market Treasury Bills Cash Management Bills GSecs T+2 T+1 or T+2 T+1 Settlement secondary market T+2 T+1 T+1 Restrictions for FII Subject to USD5bn limit on GSec Subject to USD5bn limit on GSec Subject to USD5bn limit on GSec Interest Income Tax 20% subject to DTA 20% subject to DTA 20% subject to DTA Capital gains tax 30% subject to DTA 30% subject to DTA 10% for long-term,30% for short-term subject to DTA 10% for long-term,30% for short-term subject to DTA 30% for short-term subject to DTA 30% for short-term subject to DTA 10% for long-term,30% for short-term subject to DTA 10% for long-term,30% for short-term subject to DTA

State Development Loans Commercial Paper Certificates of Deposit Corporate Bonds

T+1 or T+2

T+1

Subject to USD5bn limit on GSec

20% subject to DTA

T+0 or T+2 T+0 or T+2 T+0 or T+2

T+1 T+1 T+0 to T+2

Subject to USD15bn limit on corporate bonds Not permitted Subject to USD15bn limit on corporate bonds Subject to USD15bn limit on corporate bonds

20% subject to DTA

Public Sector Undertaking (PSU)

T+0 or T+1

T+2

20% subject to DTA

Source: RBI, CCIL, SEBI, RBS

Conclusion
While the Indian fixed income is characterised by a well-defined set of rules and regulations and a deep matured GSec market, the slow growth of the corporate bond market as well as retail investors participation are areas for future development. Although credit rating and issuer knowledge are generally quite well developed relative to other emerging markets, an active secondary market and credit curve have not fully evolved. Addressing these deficiencies are acknowledged priorities of the SEBI.

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the FIMMDA. There is no mathematical way of deriving the illiquidity premium it is generally estimated by market makers who would base it on maturity, coupon rate, issue size and distribution of the illiquid bonds.

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Glossary
Broad Based Funds This refers to a fund established or incorporated outside India having at least twenty investors with no single investor holding more than 10% of the shares or units of the fund. The exceptions to the requirements arise when the fund has institutional investors, then it is not required to have twenty investors. In the case that the institutional investor is holding more than 10 % of the shares, the institutional investor itself must be a broad based fund. BSE Bombay Stock Exchange CCIL Clearing Corporation of India Limited (CCIL) is the clearing agency for government securities. It acts as a central counterparty for all transactions of the government securities. CCIL guarantees the settlement of all the trades of all trades in the government securities. CMB Cash management bills were introduced in August 2009 to allow the government to meet temporary cash flow mismatches. Their tenors can be no more than 91 days. The government issued two such bills in H1 2010 which had since matured. CSGL Constituents Subsidiary General Ledger Account also known as SGL II account is an account in which a bank or primary dealer acting as a custodian of gilt accounts can hold its constituents. Depositories Investors can hold government securities in dematerialized account with a depository. The most prominent depositories are NSDL and CDSL. DvP Delivery versus Payment is the mode of settlement wherein the transfer of securities and funds happens simultaneously. There are three types of DvP settlements: DvP I, where the securities and the funds legs of the transactions are settled on a gross basis; DvP II, where the securities are settled on a gross basis whereas the funds are settled on a net basis; and DvP III, where both securities and funds legs are settled on a net basis. ECB External commercial borrowing limit is set by the RBI on local corporates to restrict their overseas borrowing. To promote the countrys infrastructure development plans, rules governing prior approvals and spreads over USD Libor have been relaxed for infrastructure firms in 2008. FII Foreign institutional investor refers to a non-resident investor which has been licensed by the Securities Exchange Board of India (SEBI) to trade and invest in the Indian equity and debt markets. FIMMDA Fixed income money market and derivatives association of India Gilt Account Since registration of SGL accounts with RBI is restricted, investors have the option of opening a Gilt Account with a bank of primary dealer which has a CSGL account. LAF Liquidity adjustment facility is the repo/ reverse repo window provided by the RBI for overnight borrowing or lending by the banks with the central bank. MIBOR Mumbai inter-bank offered rate Emerging Markets Asia | 17 August 2010 17

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MIFOR Mumbai inter-bank forward offered rate MSS Market stabilization scheme was introduced in 2004 for the RBI to issue GSecs to sterilize its USD buying intervention in the FX market where the proceeds of these GSec issuance would be kept in a MSS account set up at the RBI, withheld from the government so that the proceeds cannot be used for fiscal funding. NDS The negotiated dealing system was introduced in 2002 for electronic dealing and reporting of the transactions of government securities. NDS members can send in bids for primary issuance of GSecs. Membership is restricted to members holding SGL or Current accounts with RBI. NDS also facilitates settlement of transactions for GSecs in the secondary market. NDS-OM An order driven electronic system was introduced where the participants can trade anonymously by matching their orders with other market participants. Direct access to NDS-OM is available to selected commercial banks, primary dealers, insurance companies and mutual funds while others can only access this system through their custodians. NDTL Net demand and time liabilities are the base used by scheduled commercial banks to compute their required cash reserves to be placed with the RBI. NSE National stock exchange Participatory Notes (PN) These are notes issued to foreign funds with no FII licence by FII-registered institutions to trade in the domestic markets on their behalf. PSU Public sector undertaking SEBI Securities exchange board of India SGF CCIL guarantees settlement of all the trades in the government securities and provides funds/securities by its own means in case the participant fails. To hedge this risk, the CCIL collects margins from all participants and this maintained margin is called the settlement guarantee fund (SGF). It can be in the form of cash or securities (minimum 10% cash). Eligible securities for SGF are specific issues of central government securities and treasury bills listed by the CCIL through notification where the list is reviewed periodically. SGL Subsidiary General Ledger Account (SGL) facility is provided by RBI to select entities who can maintain their securities in SGL accounts with the Public Debt Office of RBI Shut Period Shut period is the period for which securities can not be delivered or settled. This shut period serves the purpose of facilitating the servicing of the security e.g. payment of coupon and redemption proceeds and to avoid any change in ownership during this process. Example if the coupon payments dates are 26th August and 26th February then the shut period will fall on 25th August and 25th February and trading in this security for settlement on these two days is not allowed. Currently the shut period for securities held in SGL accounts is one day.

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Emerging Markets Asia | 17 August 2010

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Emerging Markets Asia | 17 August 2010

Sub accounts (FII) Sub accounts refer to foreign corporates, foreign individuals and institutions, funds or portfolios established or incorporated outside India on whose behalf a registered FII can make investments.

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Appendix
List of Credit Rating Agencies, Primary Dealers and Custodians
Credit Rating Agencies CRISIL limited Fitch Ratings India Private Ltd. ICRA Limited Credit Analysis & Research Ltd. (CARE) Brickwork Ratings India Pvt ltd. Bank Primary Dealers Royal Bank of Scotland N.V. Bank of America Bank of Baroda Canara Bank Citibank N.A. Corporation Bank HDFC Bank Ltd. Hongkong and Shanghai Banking Corpn. Ltd J.P Morgan Chase N.A., Mumbai Branch Kotak Mahindra Bank Ltd. Standard Chartered Bank Registered Custodian of Securities Royal Bank of Scotland N.V. AXIS BANK BNP Paribas Citibank N.A. DBS Bank Ltd. India Deutsche Bank AG HDFC Bank Ltd. Hongkong and Shanghai Banking Corpn. Ltd ICICI Bank Ltd. IL&FS Securities Services Ltd. JPMorgan Chase Bank, N.A. Kotak Mahindra Bank Limited Orbis Financial Corporation Ltd. SBI Custodial Services Pvt. Ltd. Standard Chartered Bank Source: See list below Entities where in-principal approval has been granted India Infoline Ltd. DSP Merril Lynch Limited MF Global Sify Securities India Pvt. Ltd. Globe Capital market Ltd. Edelweiss Custodial Services Limited Standalone Primary Dealers Deutsche Securities (India) Pvt. Ltd. ICICI Securities Primary Dealership Limited IDBI Gilts Ltd. Morgan Stanley India Primary Dealer Pvt. Ltd. Nomura Fixed Income Securities Pvt. Ltd. PNB Gilts Ltd. SBI DFHI Ltd STCI Primary Dealer Limited

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Emerging Markets Asia | 17 August 2010

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List of Countries with Double Taxation Avoidance Agreement (DTAA)


Country Australia Austria Bangladesh Belarus Belgium Brazil Bulgaria Canada China Cyprus Czechoslovakia Czech Republic Denmark Egypt Finland France Germany Greece Hungary Indonesia Israel Italy Japan Jordan Kazakhstan Kenya Korea Kyrgyzstan Libya Malaysia Malta Mauritius Mongolia Morocco Namibia Nepal Netherlands New Zealand Norway Oman Philippines Poland Portugal Qatar Romania Russian Federation Singapore South Africa Spain Sri Lanka Sweden Switzerland Syria Tanzania Dividends 15 20 15 15 15 15 15 25 10 15 20 10 20 20 15 10 10 20 15 15 10 20 15 10 10 15 20 10 20 20 15 15 15 10 10 15 10 15 15 12.5 20 15 15 10 20 10 15 10 15 15 10 15 0 15 Interest 15 20 10 10 15 15 15 15 10 10 15 10 15 20 10 15 10 20 15 10 10 15 15 10 10 15 15 10 20 20 10 20 15 10 10 15 10 10 15 10 15 15 10 10 15 10 15 10 15 10 10 15 7.5 12.5 Royalties 15 30 10 15 20 15 20 15 10 15 30 10 20 30 20 20 10 30 30 15 10 20 20 20 10 20 15 15 30 30 15 15 15 10 10 15 10 10 30 15 15 22.5 10 10 22.5 10 15 10 20 10 10 20 10 20

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Emerging Markets Asia | 17 August 2010

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Thailand Trinidad and Tobago Turkey Turkmenistan United Arab Emirates United Kingdom United States Uzbekistan Vietnam Zambia

20 10 15 10 15 15 20 15 10 15

20 10 15 10 12.5 15 15 15 10 10

15 10 15 10 10 15 15 15 10 10 Source: MOF

Sources
www.rbi.org.in www.sebi.gov.in www.bseindia.com www.fimmda.org www.finmin.nic.in www.commerce.nic.in

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Emerging Markets Asia | 17 August 2010