Leveraging the debt office

Banks should become active traders in govt securities

One of the recommendations of the Financial Sector Legislative Reforms Commission (FSLRC) is to detach the public debt management function from the Reserve Bank of India (RBI). This is not a new idea; it was announced as an objective by the finance minister in the Budget speech of 2010 and work is under way to draft the required legislation. Even as it progresses, there has been debate on the desirability of this course of action. The main argument in favour of it is the potential conflict of interest between the monetary and debt management functions of the central bank. For instance, inflationary conditions may warrant a significant increase in interest rates, but this will raise the costs of borrowing for the government, which, as a debt manager, it might be reluctant to do. Be that as it may, in the Indian context, there is also a potential conflict of interest in the government managing the debt function (even if it is housed in a notionally independent organisation). Since the majority of the banking system in volume terms is owned by the government, which consistently runs a fiscal deficit, what is to stop it from asking the banks that it owns to buy up more and more of its debt, so that yields can be kept artificially low? That could happen even under the current arrangement, but there are some checks by way of the RBI ensuring that yields are not out of line with market conditions. The transition could simply result in a monetary conflict of interest being converted into a fiscal conflict of interest.

But there may be a way around this, which allows an independent public debt office (PDO) to be leveraged for a broader objective. Indian banks are required to hold 23 per cent of their demand and time liabilities in government securities, the so-called statutory liquidity ratio (SLR). This entire amount (and two per cent more) is exempted from mark-to-market requirements. This means that the balance sheets of banks are completely insulated from any changes in the prices of government securities up to the 25 per cent level. This makes investment in government securities extremely attractive for banks, which typically hold more than the SLR requirement. It also makes them more amenable to pressures from the government to buy more of these securities. This can be averted by making some simple changes.

First, the mark-to-market exemption must be withdrawn within a reasonable time frame. This will expose the banks to market risks on the government securities portfolio, which ultimately impacts the value of the asset to the owner, ie the government. Second, the SLR requirement must be removed, also within a reasonable time frame. This means that banks can choose the proportion of their portfolio that they hold in government securities, and this will eliminate the captive channel of investment that currently exists.

The larger benefit that will accrue from these changes is that banks will now become active traders in government securities and the derivatives that can be used to manage interest rate risk, as they attempt to maximise treasury earnings and minimise balance sheet erosion. This is an essential requirement for the development of an active market in government securities, much aspired but little achieved.