This Union Budget came out with an announcement that the public debt management function of the RBI will now be siphoned off to the new “Public Debt Management Agency” or PDMA. All at once there has been a flurry of news daily of how the RBI is taking this news; reports have ranged from the Governor calling it a “worthwhile move” to some claiming that the RBI is unhappy with this “siphoning” of its responsibilities even as RBI officials take great pains to explain that there is no “rift” of the RBI with the Government of India (GOI) on this.
Here’s what makes the PDMA such an important issue.
Firstly, do we need a PDMA? YES. Before saying any other thing, it’s important for us to appreciate that the PDMA is going to be necessary; it’s really not a question of if, but that of when…it can get functional. Why PDMA? Because the RBI has been traditionally looking after two functions that philosophically and practically clash with each other. If inflation control is a priority objective for the RBI, the RBI may try to fund the fiscal deficits more from the market borrowing program, thereby hiking the yields of the bonds. Now, this implies that the Government can now raise money only at higher rates. Thus, inflation control and the objective of helping the GOI to raise low cost funds stand at opposite ends of the spectrum. The idea is that the RBI will now actively engage in inflation control (as per the amendments that are currently under process on the RBI Act) as a chief priority; as you may well be aware, the RBI will “target” an inflation figure of 4% with a band of 2% around it. Even as the Central Bank now actively targets an inflation level, the entire onus of raising low cost funds for the GOI will be undertaken by the new agency- the PDMA. The bonds will be issued by the PDMA and G-sec market regulation would be done by SEBI, just as it currently does it for the corporate bonds. But what if the GOI asks the PDMA to raise too many funds for it? Well, so a fiscally responsible and committed GOI and an inflation-targeting Central Bank are the two logical precursors to setting up of the PDMA. And that is why I commented earlier that its not really a question of “if”; it seems to be more a question of “when” the PDMA could get functional.
How will establishment of the PDMA help the GOI? Currently, the GOI, facilitated by the RBI, carries out its market borrowing (around Rs.5.9 lakh crores this year) program by largely borrowing funds from the banks. As the number of participants into this niche market has been so very restricted, it has created a largely sticky yield level. Further, for balance sheet management, banks have shown a tendency to HTM (hold-to-maturity) the bonds, due to which active trading in the G-sec markets has not really taken off in India. In a bid to create more excitement on bond trading, we have seen in recent times the RBI scaling down HTM proportion of the SLR chunk of bonds. However, for the Government to truly raise funds at a lower rate, what is required is more participation i.e. deeper and broader bond markets. What is being envisaged is a liquid, broad and deep bond market, in which G-secs and corporate bonds can become true-blue investment banking instruments. This should enable the GOI to truly “discover” the bond yield, and hopefully a lower one, rather than rely on one that comes out from forcible devolution of bonds onto reluctant banks.
Does the establishment of the PDMA help other players in the market such as banks and corporate houses? Obviously, yes! Once the bond issuance function of the RBI is taken over by the PDMA, and once the numbers and varieties of securities trading firms that can demand G-secs start rising, the RBI could well be in a position to drastically reduce the SLR holdings ratio, giving banks that much more control over their liquidity and profitability management. Corporate houses obviously stand to benefit as this room created by reducing the SLR could well be used towards reducing the interest rates profile of the economy.
Further, it would be fruitful to spend a minute on understanding how the siphoning of the G-sec issuance function to the PDMA will help create a healthier monetary transmission mechanism (MTM) for India. MTM basically helps us to connect changes in the money supply to changes in the GDP, through the interest rate transmission channel. Now, in the recent past, the transmission has not really worked and especially so, in the downward direction; reductions in the policy rates haven’t necessarily changed (reduced) the lending rates offered by the banks to their end customers. One of the oft cited reasons for the weak MTM in India is the weak bond markets. Once the RBI puts in a liquidity enhancement through rate cuts, this should create more appetite for bonds, driving the yield rates down. However, HTM-savvy banks and static bond markets really mean that we have lost that precious link between policy rates and yield rates. As the yield rates do not exhibit the correlation that ought to have vis-a-vis the policy rates, the discovery of the term structure of interest rates for different instruments loses its link to policy rates, resulting in MTM failure. Siphoning off the bond issuance function to the PDMA and integrating the G-sec and corporate bonds into one market segment makes inherent sense, because it not only frees up the liquidity that is currently forcibly pushed into G-secs by the banks, but it also gives a genuine chance to the RBI to affect the real sector through a alive-n-kicking monetary transmission mechanism.
With a Government that has so recently re-affirmed its faith in the FRBM and an RBI that has a swanky new inflation target role, isn’t it too early to get into one more change? Perhaps so. But it is a healthy start and it looks like finally, bond markets will get the make-over that has long been due to them. As the Romans would have said it, alea iacta est. The die has been cast.