- Ila Patnaik
Financial Express, April 15, 2006
From April 1, 2006 the FRBM Act prohibits the RBI from participating
in the primary debt market. Until now, at the time of a primary
auction the RBI would devolve government securitites into its own
account and then offload them later. This allowed the RBI to smooth
the interest rate on government securities and thus in the market. Now
if at the time of the auction all securities have to be sold, it could
increase interest rate volatility in the market.
To tide over the immediate problem of having to sell all securities in
an auction, on April 4, RBI issued new guidelines for prmary dealers
requiring them to underwrite government bonds. However, this is only a
short term solution. At present, while large-scale deficit financing
no longer takes place, the RBI does play a significant role in
smoothing the primary market sale of bonds by GOI by occasionally
stepping in to support bond auctions.
In the light of this development the RBI Report on Currency and
Finance agrees that the case for separation of monetary policy and
debt managment has never been as compelling. When a central bank is
given both responsibilities conflicts of interest often arise between
monetary management and public debt management. For example, the
monetary authority may keep interest rates low to keep the interest
payments on public debt low.
The alternatives to the current system are either to transfer debt
management responsibility back to the government or to create a
separate debt office specifically for this purpose. For the time being
the RBI has created a functionally separate Financial Markets
Department in the RBI. However, this leaves the debt management
function with the RBI and none of the conflicts of interest issues get
resolved. �It is clear that it is time for the Ministry of Finance to
initiate the process of finding a long term solution.
Most governments issue bonds, without a role for the central bank to
buy bonds in the primary market. These countries achieve this by
having strong institutional mechanisms in both the organisation of the
primary market issuance, and, the liquidity of the secondary market.
India has major weaknesses on both these fronts. Reforms on both these
fronts will help GOI achieve bond issuance at lower interest rates,
and achieve the modern structure of government bond issuance done
without involvement of the RBI.
Many countries have a `merchant banking' function, where an agency
sells government bonds based on instructions from the budget
division. Over and above this, there is also a treasury function,
which consists of cash management, risk management, and creative
initiatives aimed at reducing the cost of government debt. GOI has
left all this to the RBI.
Further, India lacks a vibrant bond market today. There are barriers to
participation, and many potential participants are excluded. This
hurts the fiscal problem of GOI in two ways. First, if a potential
buyer of GOI bonds is excluded from market participation, this
increases the cost of funding the deficit. Second, the lack of
liquidity on the bond market induces a `liquidity premium', where
interest rates required for GOI bonds are driven up.
The secondary market is the ultimate force which determines outcomes
on the primary market. A deep and liquid secondary market is the
ultimate source of the ability of the primary market to absorb
fluctuations in bond issuance. From month to month, based on the
evolution of tax collections and expenditure, the budget division
makes demands in terms of sale of bonds. A deep and liquid market is
required to absorb the fluctuations of bond issuance by GOI, without
introducing excess volatility in interest rates.
The illiquidity of the bond market hurts GOI in two ways. First, when
a month with relatively high bond issuance takes place, the interest
rate will shoot up, thus hurting the cost of financing. Further, the
month to month fluctuations of interest rates will send out a
heightened risk perception about GOI bonds, which will induce a risk
premium. Investors will require higher interest rates to get invested
in what is perceived as a risky instrument. There is a need for
reforms aimed at obtaining a deep and liquid bond market, with a
massive scale of participation by households and firms from all across
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