Unlike central banks in most other countries, the RBI faces a conflict of interest. As the country’s debt manager, the RBI decides on the timing and composition of all government debt issuance.
This means that there’s a benefit to keeping interest rates low as it allows the government to enjoy a lower cost of funding.
If only the complexity ended there. The Indian central bank also has a number of other mandates, one of which is to manage inflation. It’s not hard to manage a circumstance where keeping interest rates low to manage borrowing costs could come into conflict with attempts to control inflation. The RBI also decides how much of the country’s existing debt it wants to buy or sell through open market operations.
These competing responsibilities give the RBI an identity crisis that not only makes its job harder, but also makes it more difficult for the country to attract foreign capital.
That is because one way for foreign investors to gauge the economic direction of a country is through the actions of the central bank. This can be difficult in India, with investors left to guess whether the RBI is helping the government control funding costs or whether it is acting to control inflation.
Such ambiguity is just one of many in the Indian market and is a reason why institutional investors have always been afraid to put their money to work.
One of the main casualties is the corporate bond market, which is suffering from a lack of liquidity and is stuck in a vicious cycle. At the moment corporates are forced to print in smaller sizes due to the lack of depth and investors are forced to buy a large portion of those bonds in order to get a meaningful holding, which further contributes to the illiquidity.
This then creates a huge mispricing in the market, with deals priced off supply imbalances rather than fundamentals. Corporate bond issues are usually sold to a few accounts only and as a result function more like a private placement market.
No wonder the Indian corporate bond market has been slow to develop. New issuance was equivalent to a little less than 4% of GDP in 2014, compared to more than 60% of GDP for government bond issuance.
One of the hoped-for outcomes of removing the RBI from its public debt duties, therefore, is a resolution of this conflict of interest. The market should, as a result, enjoy more transparency and guidance. That in turn should encourage greater foreign investment.
Not that this move is without its controversy. There are reports of a power struggle between the RBI, the finance ministry and financial regulator the Securities and Exchange Board of India. For financial markets as complicated as India’s, pushing through this reform will not provide a solution to all their troubles.
One has to start somewhere, though, and streamlining the powers of the RBI is a good step towards untangling some of the confusion. For the RBI, less really will be more.