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.