Second, the RBI acts as the investment banker of the government. This involves many conflicts of interest with monetary policy and has been one of the main reasons why the RBI has in the past recommended the setting up of a separate Debt Management Office.

Third, the bulk of government bonds are held by banks, the majority of which are public sector banks. Banks are statutorily required through the statutory liquidity ratio (SLR) to hold one-fourth of their total assets in government bonds. So banks borrow from the public and redirect that money to the government. Regardless of how large the government debt is, regardless of whether the government has the ability to pay this debt or not, the Indian public is forced to (through the intermediation of banks) lend to the government. This is not the case in developed countries, which have active government bond markets and which do not force their citizens to hold this risk.

Indeed, the bond market often demands higher interest rates when it deems the bonds to be riskier. Governments are punished by the bond market for borrowing too much. Our public sector banks have little choice in the matter.

Let us not forget that the government’s investment banker also regulates banks. It can offload risky government bonds on banks and overlook the risks when it comes to bank supervision. While explicit costs remain high, implicit costs through higher risk in the banking system are high. Also when banks are forced to lend cheaply to the government they recover their costs of deposits from the private sector. This shifts the burden to individuals and households borrowing from banks.

... contd.