In this year’s budget, the government proposed to institutionally separate debt management from monetary policy. This is a watershed reform. But rather than celebrating, many have questioned its wisdom with arguments that one thought had been settled in the last 25 years of policy debate. Full disclosure: I chaired the 2008 government working group on designing an independent public debt management agency (PDMA). Prima facie, this makes me biased, but it is hard to be balanced because, in my view, there aren’t two sides to this issue.
Since the late 1980s, almost every OECD and major emerging market has established such an agency. At least since the Narasimhan Committee (1991) and the RBI annual reports (2001 and 2006), the need for functional separation of debt management and monetary policy has been established. At least since the Vijay Kelkar report (2004), which was endorsed later by the Percy Mistry (2007) and the Raghuram Rajan (2008) Committees, the need to also institutionally separate the two functions has been exhorted. In the 2013 Srikrishna report that proposes to restructure all financial laws and regulations into a single code, the PDMA occupies a central place.
There are many reasons why government debt should be managed by a PDMA, and any of the above reports lists them. Here, let me discuss just one.
There is uniform recognition that India needs to raise $1 trillion or more to finance its infrastructure needs. Given the long-term nature of these projects, it is also well accepted that bond funding will need to do the heavy lifting. However, India’s corporate bond market remains weak and has little chance of developing if the government bond market itself doesn’t deepen. On size and market turnover, India’s government market looks good, but the narrow spectrum of participants comprising the RBI, commercial banks and a handful of institutional investors means that it is unable to access the large pool of savings that, for example, goes into gold purchases. If the government can’t access these funds, what chance do corporations have?
A key reason behind this is the extensive financial repression in the bond market. As the bank supervisor, the RBI regulates the minimum amount of bonds a bank needs to hold (the statutory liquidity requirement). As the government’s debt manager, it decides the timing and the composition of all new debt issued (the bond auctions). And as the country’s monetary authority, the RBI decides how much of the old debt it wants to buy or sell (open market operations). And it can change any of these at any time.
Consider the two-year period over 2011-12. Growth was slowing but it still averaged 6 per cent. Inflation was raging at around 9 per cent. India’s overall fiscal deficit stood at over 8 per cent of GDP. Yet, the interest rate on government bonds was less than 8.5 per cent and that on corporations modestly higher at 9.5 per cent. Any pricing model based on economic fundamentals and the fiscal position would suggest that these interest rates were significantly below par. Why did this happen? Largely because, over these two years, the RBI purchased bonds from the market equivalent of one-third of the Central government’s borrowing requirement!
This, unfortunately, wasn’t an isolated episode. Over the past 40 years, bond interest rates have been consistently lower than what one would normally assess based on fundamentals. As corporate bonds are priced off government debt, their prices too have rarely borne any resemblance to economic reality. With such extensive mispricing, it is hard to see the bond market attract newer pools of savings, even if other structural reforms are implemented. Taking away debt management from the RBI doesn’t solve the mispricing, but it is the obvious first step. To be sure, the RBI didn’t volunteer to be the debt manager. It was asked to do so. And one is glad to see the government taking responsibility of managing its own debt.
Three broad sets of criticisms have been levelled against this move. The most insidious are the innuendoes that this is an attempt to weaken the power and independence of the RBI. The truth is the opposite. Critical to making the central bank formally independent is mandating it with a single and transparent objective, for example, inflation targeting, as set out in the MoU signed between the government and the RBI this February. But such an MoU has no credibility if the central bank remains burdened with debt management, as one can never be sure when an RBI policy action is driven by its mandate to keep the government’s interest costs low or by its mandate to keep inflation low.
Less insidious but laced with hints of impending doom is the argument that this is a bad time to make the change. Why? Because India still has a large debt problem and is struggling to bring down its budget deficit. This change can blow up the government’s interest costs, jeopardising much-needed funds for development. If there is one lesson that can be drawn from making the RBI manage government debt, it is that this practice has accommodated the government’s profligate ways by keeping the interest cost well below par. With not having to face the true cost of its easy fiscal policy, the government has taken fiscal consolidation more lightly than it would otherwise. Imagine if, during 2011-12, the interest rate on government bonds was upwards of 15 per cent, as the growth-inflation dynamics then suggested. We would not have had to wait for the US Federal Reserve taper fears in 2013 to start consolidating.
Then there are fears about potential market volatility, as debt management is shifted to the new agency. The government and the RBI are likely to work closely to minimise any collateral damage. But despite their efforts, teething problems might well create unwarranted volatility. But the cost of such volatility pales in comparison to what the economy has already paid and continues to pay for mispricing bond prices, obfuscating the intent of central bank policy actions, and indulging fiscal imprudence. We should have put an end to these many years ago.
One last thought. In the last 30 years, none of the countries that shifted to an independent PDMA has asked its central bank to take back debt management responsibilities.
The writer is chief Asia economist, J.P. Morgan. Views are personal.