Agenda For Internal Debt Reforms

The prospect of an internal debt explosion stares starkly in the face. Innumerable reports from the Reserve Bank of India (RBI), finance commissions and reports of the Comptroller and Auditor General of India (CAG) as well as finance ministers have highlighted the serious problem posed by the unbridled increase in internal debt. While the RBI, as the internal debt manager, has handled a difficult task extremely well its best has not been good enough. The time is long past to continue with namby-pamby patch-work solutions and radical surgery is the only option. For some years now there has been talk about a Fiscal Responsibility Act (FRA) and after much heralding of the birth of the Bill, suddenly there is no sign of life. The Constitution Review Committee would need to give attention to issues like the ceiling on public debt. Issues like a Consolidated Sinking Fund(CFS), a separate ,i>Office of Public Debt and the mandatory withdrawal of the RBI from all primary issues of government debt would need to be covered by the FRA. If the FRA is to have meaning there should be a clear delineation of internal debt from monetary policy. An RBI Informal Working Group favoured a separation of debt management and monetary policy. If one reads the tea leaves, the RBI top management is against such a separation on the ground that as part of sequencing of reforms, the separation should take place after financial markets develop. To say the least, this is most worrisome, as in the RBI's own mind, monetary management becomes a poor cousin of a dominant debt management. In such a situation one can say good-bye to the development of financial markets and the emergence of an independent monetary policy. The above issues are admittedly matters of overall economic policy co-ordination and one hopes the powers-that-be recognise that they have reached the precipice. The RBI should, nonetheless on its own, initiate a step by step institutional reform. There must be a rapid increase in the number of primary dealers (PDs) from 15 dealers to, say, 30 dealers; the increased number is merely indicative to say that over the next two to three years the total financial strength of the PDs taken together should double. Each PD must be made to bid a minimum portion of the total amount of each issue. The PDs would be free to bid at their own prices/yields and any allocations should be at the bid or more favourable if there is a uniform auction price/yield. In such a system there would be no devolvement and no underwriting commission. It is surprising that well established institutions like the Life Insurance Corporation (LIC), Unit Trust of India (UTI) and Housing Development Finance Corporation (HDFC) have taken all kinds of opportunities to expand into other financial services but have totally ignored the long-term benefits of becoming a PD. All big boys in the financial sector should think sharp. The PD gateway would not remain open for ever and those who miss the boat will live to rue at lost opportunities. Once the number of PDs is increased to attain such a strength that the PDs together can subscribe significantly more than the amount to be raised in the primary issues, the PDs would be anointed and given exclusive rights of subscribing to primary issues. Many consider this a pipe-dream but it is just possible that the fiscal deficit becomes reasonably small but institutional development lags behind. At the present time, the authorities have too many conflicting objectives. To placate the insatiable appetite of the government, the RBI has the unenviable choice of either monetising the borrowing or wrecking the market; more recently the RBI has probably done both! Following the egalitarian principle, the RBI would be allergic to restricting primary issues to the big boys club. The RBI must, however, recognise that there is something called a wholesale market and a wholesale financial market is necessary for financial development. At the other extreme, the RBI has made no public noises when dedicated gilt funds and retail investors in gilts have been slaughtered to satisfy large investors; this is truly a fiscal atrocity. It is to the credit of the CAG for having pointed out in its recent report that the removal of the tax on an individual's income from company dividends was an improper measure. It is the duty of the RBI to speak up in the interests of retail investors in gilts. The RBI must assert that interest rate formation is a monetary policy prerogative and internal debt management must be undertaken within the interest rate structure resulting from the extant monetary policy. Interest rate movements impinge on all borrowers and the government cannot be exempt. The debt manager would want the long-term rate to be unaffected by short-term and transient changes but must remember the basic dictum that the long rate is the average of the anticipated future short rates. If the anticipation is that future short rates will rise, an increase in long rates is inevitable. The internal debt manager has to learn to yield to markets without becoming a hostage to unreasonable demands. In the current context, the debt manager should cut the agony and raise longer rates, albeit more gently than the short rates. The debt manager should use interest rates to advantage but not fight fundamentals. The RBI must initiate a public debate on a Consolidated Sinking Fund (CSF) for the central government. It is improper of the Centre to encourage the states to set up a CSF and then refuse to do it as part of its own discipline. Moreover, the RBI must insist with government that a part of the profit transfer from the RBI should be earmarked to a CSF. The strongest argument against a CSF is that the burden on government increases today to alleviate it tomorrow. Central banks the world over are articulating their central concerns and generating public support for their objectives. Increasingly, it is being realised that politicians are not the be-all and end-all of society. If we in India aspire to project ourselves as a model civil society we have a lot of catching up to do. In a civil society there need to be a number of standard bearers who are unaffected by the electoral quinquennial and the central bank should certainly be one such standard bearer. To some it may, prima facie, appear irrelevant or premature to talk about an independent or autonomous central bank given the state of the political economy of the country. Such an approach would be unfortunate. India would do well to study recent developments relating to the Reserve Bank of South Africa and its articulation of it being one of the independent standard bearer's of society. Such a move would be a basic prerequisite for India to move to a civil society. But before all this, the RBI has to take steps to throw off the yoke of internal debt and for this to happen there must be serious thought given to the sequencing and timing of reforms in the area of internal debt.