What is the right time for setting up the DMO?

Financial Express, 12 August 2009

When a problem is easy, it is okay to get by with a hastily patched up solution. But when a problem is really daunting, a top quality solution is called for. India's fiscal problem is really daunting. Hence, a top quality solution is required for government's problem of investment banking. This requires setting up a new independent Debt Management Office (DMO), which has been termed `National Treasury Management Agency' (NTMA) in the Indian discourse.

First consider a company like Infosys, which has practically no debt. Suppose Infosys sets out to issue Rs.1,000 crore of bonds. This is fairly easy. The CFO of Infosys can speak with a few of his personal friends, and the job will get easily done.

Instead of Infosys, suppose there is a highly indebted company. The market is worried about the soundness of this company. Credit rating agencies are putting out warning sounds. For this company, bond issuance is not easy. If the CFO of the company is relaxed about it, bond issuance could easily become a mess. The interest rates paid could go up dramatically.

A highly indebted company cannot get by with a poor investment banking solution. It needs to think hard about how it will get this done. It needs to contract with the best investment banker available. It has to worry about the capabilities and professionalism of the investment banker. It has to worry about any potential conflicts of interest of the investment banker, and choose an agent who has a loyalty to only one task: that of getting the investment banking job done at the lowest possible cost of capital.

This example gives us useful insights when thinking about putting debt management for the government on a sound footing. In the decades leading up to the RBI Act of 1934, when this Act was conceptualised, little was known about economics and finance. The Indian government had little debt. A certain clumsy arrangement was setup, where RBI was the debt manager of the government. Nobody can argue that this was a particularly well thought out structure, or one that is in line with our present understanding of economics.

In following decades, all good countries have understood that a central bank must not be burdened with the job of investment banking. It is a basic conflict of interest: on one hand, a central bank sets the short-term interest rate; on the other hand, the investment banker tries to sell bonds at low interest rates. All good countries have taken the investment banking function out of the central bank. In the UK -- which is the country which saddled us with this RBI Act -- the investment banking function is placed in a separate Debt Management Office, which works as an agent of their MOF.

RBI annual reports have argued that doing a good job of being a central bank requires shedding the investment banking function. Every RBI governor has complained about how it is hard to do monetary policy while being asked to sell bonds for the government. A series of expert committees have recommended the establishment of the `National Treasury Management Agency'. These include groups headed by Kelkar, Mistry and Rajan. Draft legislation has been created, by the Jahangir Aziz Working Group.

Anyone who aspires for a strong and capable central bank, one that raises interest rates in good times and cuts them in bad times, knows that such a central bank should not be burdened with extraneous functions. The people who insist on placing multiple conflicting functions at RBI are keen on undermining the power of monetary policy.

In recent weeks, a conservative rearguard action has come back to life, where the argument is made that because there is a large fiscal problem today, the establishment of the NTMA should not be done now. The basic logic of NTMA is conceded, but a delaying tactic is proposed.

This needs to be rejected for two reasons. First, it is precisely when there is a fiscal mess that a professional and focused NTMA adds the most value. WPI inflation has crashed from a period with annualised inflation of 15% to current values of 4%. There has been an 1100 basis point drop in inflation. This should yield a sharp drop in the cost of financing of the government. MOF should be asking difficult questions of their agent (i.e. their investment banker) about why the cost of borrowing has not improved significantly.

The second reason lies in the life cycle of UPA-II. If UPA-II builds NTMA today, it will reap the fruits within two years. If an unreconstructed RBI persists, then the benefits to this UPA administration from setting up the NTMA would be reduced. Major economic reform announcements are good for the economy by boosting confidence in India's future, and spurring private corporate investment. So the news that India will setup NTMA will exert a positive effect upon the economy. But the tangible benefit to the UPA, of a reduced cost of funds, will not come about in the 2009-2014 period if the delaying tactics succeed.

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