## Saturday, March 21, 2015

### Clear thinking on today's RBI question

Sugata Ghosh has an article in the Economic Times titled RBI wants to control both prices and debt market, but government refuses to oblige. Some of this needs to be seen differently. He says:

For the market, there cannot be an I-banker that's more honest and effective than RBI. It's the perfect insider with all powers — it can cancel an auction, buy or sell bonds in the secondary market to generate or absorb excess liquidity, and it regulates many of the investors subscribing to government bonds. Also, there is no debate that RBI acts in the best interest of the fisc.
Do you really want to buy bonds from someone who has insider information on how interest rates will go in the future? It's like trading against a corporate insider in the secondary market for equity. The text above violates the basic logic about why central banks, all over the world, have got out of debt management.

MOF insiders will tell you numerous stories where RBI violated the best interests of the exchequer in the pursuit of other objectives. The trouble is, when you have multiple objectives, you are accountable for none. "Why did you fail on inflation?" "Because we were chasing debt management." "Why did you fail on debt management?" "Because we were chasing inflation." Placing multiple objectives on one Agent, which internally conflict with each other, is bad management by the Principal.

The world over, we separate these things out. The central bank is accountable for delivering CPI inflation within the target zone -- and nothing else. The debt management office is accountable for delivering low cost of borrowing for the government in the long run -- and nothing else. There are no conflicts of interest. The buyer of bonds from the DMO is not worried that he's trading against an insider. The Principal is able to hold both Agents accountable; the Agents don't have plausible deniability in explaining away failure.

If RBI was such a great debt manager, why is it that every single expert committee, and the RBI board, all agreed that it made sense to unburden RBI of the conflict of interest of debt management? A little googling would dig out the logic as articulated in (1) RBI annual reports, (2) the Jahangir Aziz Working Group, (3) the M. Govinda Rao Working Group, (4) the Justice Srikrishna Commission, (5) the Percy Mistry Committee, (6) the Raghuram Rajan Committee and (7) the Vijay Kelkar Committee on MOF restructuring. Not one of these disagreed with the reforms which are now being implemented.

What RBI faces in the old arrangement is a mugs game; RBI lurches from one problem to another. It is easy to criticise RBI, but what's going on is a deeper problem, of a badly structured set of contracts where Ministry of Finance has not allocated the work properly. That deeper problem must be addressed. This is a three-pronged story: (1) Give clarity to RBI that it's job is to deliver CPI inflation; (2) Undertake bond market reforms so that RBI gets a monetary policy transmission; and (3) Unburden RBI of the investment banking function.

Sugata Ghosh also says:

Will the bond market deepen if it moves out of RBI? Ask anyone in the cosy world of bonds, and she would say 'no'.

Insiders in a closed club always love the status quo. Nobody wants to open up a closed club.

Lawyers in India do not want new players to come in.

The old BSE members did not want to admit new members, and they did not want NSE. I could easily paraphrase the above sentence and it tells you the newspaper story of 1992: "Will the stock market deepen if MOF creates NSE and opens up entry? Ask anyone in the cosy world of the BSE and she would say 'no'."

The bond market in South Bombay is a nice closed club -- only banks and PDs welcome. Thousands of sophisticated securities firms are forcibly excluded from this market. Their participation will increase liquidity and market efficiency. This is good for the exchequer, as they will get better pricing when selling into a more liquid and more efficient market.

The incumbents in a closed club market are never going to be enthusiastic about change. BSE members today make more money than they did in the old system -- but they ferociously lobbied against the change.

The fundamental law of securities market development is that we get a deep and liquid market by opening up entry barriers. By the act of opening up a closed club, the market will be made to work better.

Again, the author should consider why every single expert committee has advocated merging all organised financial trading into one regulator: SEBI (or its successor, the UFA). This includes spot or derivatives. This includes equities, bonds, commodity futures, currencies, etc.

There used to be ferocious protests from one player in commodities against this plan of unifying commodity futures into organised financial trading. We saw how that worked out, and that should give caution to journalists listening to vociferous practitioners. Now FMC is merging into SEBI. One by one, the remaining pieces should follow.

1. It makes sense to place one agency responsible for one objective. But is CPI inflation targeting the right objective for RBI? CPI represents just one basket of commodities towards which money flows. Variables such as income distribution, demographics, consumer preferences related to quality of living trends etc play bigger roles to influence CPI than what RBI can possibly influence. RBI may be in a better position to influence asset prices than CPI.
It is probably a stupid idea to expect RBI to control CPI. I do not know what a meaningful objective for RBI could be.

2. Don't agree there is a conflict of interest. In the case of a profligate government, the task of RBI becomes more difficult. At least this way, we can hold RBI partly responsible for a rise in inflation if there is indiscriminate borrowing. Plus you never know how the other agent is going to be. It has to be at least as credible as RBI in managing the government while also managing the debt program

3. I completely agree with you that bond market must be deepened and must be opened up to all players. However, I do not agree with you that the debt management must lie outside of RBI at this stage. This is simply because the Indian currency is not yet fully convertible. The value of the currency directly affects inflation in India. And therefore, the value of the currency must be closely monitored. The flows from foreign investors directly affects the value of currency, which in turn affects inflation. And because the MOF has given the RBI the dual mandate of "targeting and controlling" inflation at 4% within +/- 2% band to RBI, the debt management therefore must reside with RBI. Otherwise the politicians will end up playing with inflation and interest rate! And it will defeat the whole purpose of RBI taming the inflation.

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