Transparency in state bonds

RBI right to link banks’ valuation to market prices

The Reserve Bank of India (RBI) has announced major changes to how banks will have to value state government bonds, with far-reaching implications for the bond market and for state and central finances. Currently, state government bonds are accounted for on banks’ books using a straightforward yield-to-maturity approach; all state government debt, irrespective of which state has issued it, is marked up at 25 basis points above the yield of the equivalent Union government security, or G-Sec. This enforced uniformity will soon end, to be replaced with a valuation that is more closely tied to observed market prices. This is relatively easy to do for those state government securities that are regularly traded; for those that are not, the RBI said that “the valuation shall be based on the state-specific weighted average spread over the yield of the central government securities of equivalent maturity, as observed at primary auctions”. More will be known about this mechanism when detailed guidelines are issued next week, but the implications of the shift are already clear.

For public sector banks that are already looking at a ~200 billion loss on markto-market provisions in the first quarter of the current financial year, following a months-long rout in the bond market, this is not good news. Another tranche of their treasury holdings will be exposed to market forces. While the RBI has permitted the banks to spread out their treasury losses in the quarter ending in June over the four quarters of the year, that may not be enough of a compensation — from banks’ point of view — for the additional instability to their treasury account introduced by a market-linked valuation for state government securities. So far, banks have been booking easy profits on state government bonds thanks to the fixed premium rule. The absence of that fixed premium not only means that this path to easy profits is closed, but that there is the very real possibility of additional losses depending on the future direction of the government bond market.

For state governments, meanwhile, this is a wake-up call. Part of the reason for the bond market rout over the past year has been the over-supply of state, central and quasi-government paper. The simple 25-basis-point rule allowed states, even profligate and populist ones, to raise money easily from the markets. The market was not allowed to discipline poorly run or profligate states. The RBI, worried about the general government deficit, has taken a canny approach: It cannot change a state government’s fiscal incentives directly, but has done so indirectly. This will also allow greater transparency in public finance. There is no reason why the bond markets should treat a debt-ridden state or a fiscally profligate one identically to states that are more careful about their fiscal position. Banks may complain, but it also introduces greater transparency to their books. States may complain, but this move forces them to reform expenditure and revenue. While yields may continue to rise as a response to lower demand, in the long run the RBI’s move will strengthen the bond market.