Needed, a deep and liquid bond market

Written by Ila Patnaik | Updated: Apr 11 2006, 05:30am hrs
From April 1, 2006, the FRBM Act prohibits the Reserve Bank of India (RBI) from participating in the primary debt market. Until now, at the time of a primary auction, RBI would devolve government securitites into its own account and offload them later. This allowed RBI to smoothen the interest rate on government securities and thus in the market. Now, if at the time of the auction all securities have to be sold, it could increase interest rate volatility.

To tide over the immediate problem of having to sell all securities in an auction, on April 4, RBI issued new guidelines for primary dealers requiring them to underwrite government bonds. How-ever, this is only a short-term solution. At present, while large-scale deficit financing no longer takes place, RBI does play a significant role in smoothening the primary market sale of bonds by the government by occasionally stepping in to support bond auctions.

In the light of this development, the RBI Report on Currency and Finance agrees that the case for separation of monetary policy and debt management has never been as compelling. When a central bank is given both responsibilities, conflicts of interest often arise between monetary management and public debt management. For example, the monetary authority may keep interest rates low to keep the interest payments on public debt low.

The alternatives to the current system are either to transfer debt management responsibility back to the government, or to create a separate debt office specifically for this purpose. For the time being, RBI has created a functionally separate financial markets department. However, this leaves the debt management function with the RBI and none of the conflicts of interest issues get resolved. It is clear that it is time for the ministry of finance to initiate the process of finding a long-term solution.

Most governments issue bonds without a role for the central bank to buy bonds in the primary market. These countries achieve this by having strong institutional mechanisms in both the organisation of the primary market issuance and the liquidity of the secondary market.

Most govts issue bonds without central banks playing a role in buying them
They have the advantage of active primary and secondary markets
India, however, has substantial weaknesses on both fronts
India has major weaknesses on both these fronts. Reforms on both these fronts will help the government achieve bond issuance at lower interest rates, and achieve the modern structure of government bond issuance done without RBI involvement.

Many countries have a merchant banking function, where an agency sells government bonds based on instructions from the budget division. Over and above this, there is also a treasury function, which consists of cash management, risk management, and creative initiatives aimed at reducing the cost of government debt. The government has left all this to RBI.

Further, India lacks a vibrant bond market today. There are barriers to participation, and many potential participants are excluded. This hurts the fiscal problem of the government in two ways. First, if a potential buyer of government bonds is excluded from market participation, this increases the cost of funding the deficit. Second, the lack of liquidity on the bond market induces a liquidity premium, where interest rates required for government bonds are driven up.

The secondary market is the ultimate force which determines outcomes on the primary market. A deep and liquid secondary market is the ultimate source of the ability of the primary market to absorb fluctuations in bond issuance. From month to month, based on the evolution of tax collections and expenditure, the budget division makes demands in terms of sale of bonds. A deep and liquid market is required to absorb the fluctuations of bond issuance by the government without introducing excess volatility in interest rates.

The illiquidity of the bond market hurts the government in two ways. First, when a month with relatively high bond issuance takes place, the interest rate will shoot up, thus hurting the cost of financing. Further, the month to month fluctuations of interest rate will send out a heightened risk perception about government bonds, which will induce a risk premium. Investors will require higher interest rates to get invested in what is perceived as a risky instrument. There is a need for reforms aimed at obtaining a deep and liquid bond market, with a massive scale of participation by households and firms from all across the country.