Public debt management: back to school
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There is currently an intense public debate about the location of public debt management in India. At present, we are in limbo, with the ministry of finance recently retracting the provisions in the Finance Bill pertaining to the establishment of a separate Public Debt Management Agency (PDMA). As a result, these functions will continue to be run from the Reserve Bank of India (RBI), but the statement of finance minister Arun Jaitley leaves considerable ambiguity about when (and if) these functions will be transferred to the finance ministry’s control.
Does economic theory offer any guidance about the optimal management of government debt?
One of the fundamental concepts in thinking about government debt is Ricardian Equivalence. David Ricardo posited in the 1800s that since debt must eventually be repaid by governments, it is essentially equivalent to future taxation (and will be perceived as such by taxpayers). Essentially all work in economics on public debt management relies on this concept in one way or another.
If debt and future tax policy are two sides of the same coin, the obvious step is to think through the role of debt in the context of sensible tax policy. In public finance theory, it is well-known that certain types of taxation, such as income taxes, can distort the incentives of economic agents. As a result, one goal of debt policy is to smooth out tax-induced distortions, especially when the economy is faced with adverse shocks.
As an example, consider what might happen if Greece suddenly exits the euro in the next year or so. The impacts on global demand (and consequently on the Indian economy) of a Grexit could be significant. This shock to Indian gross domestic product (GDP) would make it harder to pay our debt obligations, necessitating increases in (distortionary) taxation in order to avoid a payments crisis. If India were somehow able to issue debt structured such that repayments in the event of a Grexit are lower, this would reduce the burden on tax policy.
Such state-contingent debt is rarely available since debt contracts are standardized for good reasons. Working with these contracts implies a complex trading strategy to create the optimal debt portfolio, taking into account liability constraints faced by the government. The complexity increases because issuing and trading government debt faces real-world issues such as liquidity, contract structuring, and anticipating the incentives of potential purchasers. This complex task, in a nutshell, is the role of the public debt manager.
Indeed, optimal public debt management is even more complex than outlined above.
Should debt be nominal or inflation-indexed? This depends on the nature of the shocks facing the economy. For example, if shocks necessitate increases in public spending (think monsoons failing), then nominal debt may be optimal since the ensuing inflation will reduce the real value of these public spending increases (and once again, smooth the need for tax increases at such times). Conversely, indexed debt can be optimal in circumstances where more purely monetary shocks hit the economy. In general, the optimal policy will require a mix.
Another important issue is the currency composition of public debt, which depends on the correlations between foreign and domestic output and monetary shocks. Once again, the optimal policy will generally have a mix of foreign and domestic debt. There is also the question of the optimal maturity of public debt, which is an important and tricky implementation challenge which depends on market realities such as liquidity and rollover risk.
A quick note is warranted on the issue of conflicts of interest, between the objectives of RBI in its inflation-fighting and public debt management roles, that has come up repeatedly in this debate. In practice, this is not likely to be a major issue, since there are severe reputational costs associated with changing monetary policy depending on the outstanding stock of debt. The empirical evidence shows that there is little evidence of inflation increases even during growth crises, perhaps for this reason.
While optimal debt management is extremely complex, we can say some things with certainty. Clearly, optimal debt management is linked inextricably with the conduct of fiscal policy. It is a task requiring significant and cutting-edge asset management expertise. In an open economy such as our own, the debt manager will also need institutional knowledge of both foreign and domestic money markets.
On balance, this does seem like more a fiscal than a monetary responsibility (although both competencies are required), meaning that the natural home for the PDMA is ministry of finance. This is likely why most Organisation for Economic Co-operation and Development countries locate their debt management agencies in their Treasury ministries. But whatever solution emerges, the main focus should be to develop the competency to manage this complex asset management function in the best possible manner. That is a bigger challenge than any turf wars on where the function is located.
Tarun Ramadorai is professor of financial economics at the Saïd Business School, University of Oxford, and a member of the Oxford-Man Institute of Quantitative Finance.
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