The Reserve Bank of India (RBI) manages the borrowings of the government. There has hardly been a year after independence that the government has had a surplus. It has had to borrow from the market to meet capital requirements for plan schemes. In fact, the argument among financial managers of the government was that there was no harm in running a fiscal deficit if the funds were used for capital expenditure. These substantial borrowings from the market have been managed by RBI in a manner that targets are fulfilled without affecting the credit flow to the rest of the economy. RBI decides on the tranches of government borrowing at different times of the year, the periodicity and the coupon rate, and “persuades” state-owned banks to pick up the bonds, which are then counted as part of their statutory liquidity ratio. Apart from this, RBI manages the borrowings of state governments as well, taking into account their needs and their capacities. In fact, RBI has been the debt and treasury manager to the government.
There have been some problems with this. First, in order to be an effective bond manager, it would like to keep interest rates low, but this constrains the monetary policy freedom of setting short-term interest rates. Second, these bonds are illiquid, with trading taking place only between different public sector banks that hold them, and are, thus, non-transparent. It has also constrained the development of a bond market where the public could buy and sell government bonds. It has also prevented companies from accessing market for debt financing, as long-term bonds have not developed in the secondary markets.
In the last decade, the situation has changed significantly. The equity markets have become world class and there has not been a single day, even in the current crisis, that markets have not functioned and settlements have not taken place. State government borrowings have been made independent of Central oversight on Plan expenditure after the 12th Finance Commission recommendations and they can now borrow according to their credit-worthiness as needed.
It was against the backdrop of creating a smooth, independent bond market that the government announced in the 2007-08 Budget that the monetary management and debt management aspects of RBI would be separated. On Friday, the government released a draft Bill to create a statutory corporate body called the National Treasury Management Agency (NTMA) to carry out debt management, cash management and management of contingent and other liabilities of the Centre and states. The agency will help them manage their debt to allow them to meet their financing needs. The agency will, over time, be able to extend the portfolio of debt instruments to include rupee-denominated bonds, foreign currency-denominated bonds as well as inflation-indexed bonds. This is a welcome move, and will help create a vibrant bond market, and impart greater strength and depth to our financial markets.
At the same time, there is a moral hazard as well. First, a role of RBI, one it has ably executed for the last 60 years, is being curtailed in favour of NTMA which will, as the investment banker to the government, work with the budget division of the ministry of finance, without oversight from the central bank. NTMA will be an investment banker without any regulatory oversight. In the past, there have been several state governments that have been remarkably indiscreet in their borrowings, primarily to pay for subsidies and dole. With RBI in control, and the states needing overdraft and ways and means facilities, RBI was able to provide effective oversight to state finances. There have been several instances where RBI has bailed out states through proactive advice and assistance. With the proposed NTMA, this role will cease to exist. There is no evidence to suggest that states, and indeed even the Union government, have been able to rise above politics and manage their finances in an objective and prudent manner. NTMA will be unable to prevent indiscreet borrowings by the states, for it is slated to be an investment manager, not a fiscal regulator.
Second, the draft Bill envisages that government bonds will be available for sale in India and abroad. This will mean that for the first time since independence, we will be offering sovereign bonds to overseas investors. Earlier, finance ministers and governments have shied away from this, for committing a sovereign to a debt that can be called outside the country has been a very sensitive and emotional issue. It has been a principle so far that the sovereign, the state, would not issue debt overseas.
Once again, in our history of reforms, we are creating instruments without taking care to see whether institutions are sufficiently mature and developed to use instruments in a balanced way.
S. Narayan is a former finance secretary and economic adviser to the prime minister. We welcome your comments at firstname.lastname@example.org