I wrote a column in the Financial Express today about the reported views of the Reserve Bank of India on the establishment of a Debt Management Office in India.
I deliberately avoided mentioning monetary policy anywhere in the whole column, but focused on the implications for the government securities market and for borrowing costs.
The reported suggestion by RBI to postpone the establishment of a debt management office (DMO) is not a good idea. An independent DMO would help create a vibrant and dynamic government debt market, and would reduce the government’s borrowing cost in the long run.
It is worth remembering that the development of a vibrant government debt market is one of the few financial innovations that have changed the course of world history. Beginning with sixteenth century Holland, whose war for independence from the Spanish Empire was immensely aided by its superior debt market, it has been true that governments that have been able to borrow from willing lenders have prevailed over those that have had to rely on forced loans.
India is today at a stage in its economic and financial development where it needs to shift from relying on captive buyers of government securities (the modern day equivalent of forced loans) to creating a deep market of willing buyers for its debt. I see the DMO as an essential and valuable step in this direction.
When a private sector company issues securities, it goes to great lengths to assess investor appetite for different kinds of securities and tries to tailor its securities accordingly. It works with its investment bankers to improve the liquidity of its securities because it knows that higher liquidity ultimately reduces the cost of its borrowing.
Until the late twentieth century, governments around the world were insufficiently sensitive to these factors and often behaved in a distinctly investor unfriendly way. All that has changed with the creation of professionally managed debt management offices in country after country both in the developed world and in emerging markets.
These DMOs look at debt issuance exactly the way a corporate treasurer looks at corporate debt issuance. They have a mandate to borrow at the lowest possible cost, and they know that they can do this only by making their securities attractive to investors. DMOs around the world have worked on making the systems for issuing, trading and settling government securities much more investor friendly.
Partly as a result of this, government debt markets globally have evolved in depth, liquidity and sophistication. For too long, India has relied on the easy route of placing government securities with captive banks and insurance companies. The unfortunate side effect of doing this is that the development of government securities markets in India has been stunted.
Thanks to our fiscal profligacy, India has a large outstanding stock of government securities as a percentage of GDP. This large stock of debt provides a foundation for a very liquid and deep market. Unfortunately, this potential has not been realised.
Other than a few on “the run securities”, most government securities are hardly traded. Even the market for liquid “the run securities” securities lacks diversity of players. Government securities is largely an inter bank market. As a result, when there is a liquidity shock to the banking system, the government securities market becomes a one sided market. It lacks resilience – the ability of the market to quickly return to normalcy after a large shock.
A professionally managed DMO should change all this. In the long run, the establishment of a DMO with a clear mandate and accountability would help reduce borrowing costs for the government in many ways. Unlike the RBI or the Ministry of Finance, the DMO has only one function and a very well defined objective. This makes it easy to measure the performance of the DMO.
When one reads the audit reports evaluating the DMOs of some leading countries in the world, one is impressed by the clarity of discussion on factors like the maturity composition of debt that impact the borrowing cost of the government. In India by contrast, there is today no real accountability for the interest cost of the government, which is currently the single biggest item of government expenditure.
Apart from lower borrowing costs for the government, there are many other benefits from a liquid and well developed market for government bonds. The yield curve for “risk free” government securities is the benchmark for all other interest rates in the economy.
The lack of a reliable and robust yield curve in the Indian government securities market impedes the valuation and trading of other debt securities as well. In other words, a sophisticated government securities market is the first step to the creation of a vibrant corporate debt market.
I believe therefore that India should not waste any time in setting up a professionally managed DMO. What about the argument that this is the wrong time to do so because of the large borrowing programme this year? The savings pool in India is deep enough for the government to borrow enough to cover its fiscal deficit in the free market. No, we do not need “forced loans” – at least not yet.