There's a lot the ECB can learn from the RBI

How can Italy's problem be solved? One way is to move out of the euro and denominate the debt in lira (the Italian currency before the euro). By doing this, Italy can print money to repay bondholders. But Italy and the EU (European Union) do not want that (Italy moving out of the eurozone).

The other way is to make the European Central Bank (ECB) more proactive and accountable for Italian debt. That means the ECB should manage Italy's debt; doing so will calm investors because the ECB managing Italy's debt is better than Italy managing that debt.

The second way already exists in India, and the ECB should learn from the RBI on how to go about managing Italy's debt.

 Theres a lot the ECB can learn from the RBI

The European Central Bank President Mario Draghi. Reuters

The RBI, apart from managing central government debt, also manages state government debt.

India has 28 states and the RBI manages the borrowing for states. Each state has its own budget and the financial position differ from state to state.

State government bonds, called SDLs or state development loans, carry credit risk. States cannot print money to repay bondholders unlike the central government.

However, despite some states having weak financials, borrowing costs for states do not shoot up in relation to central government borrowing costs. Ten-year SDLs trade at spreads of around 30 basis points over 10-year government bonds. This spread has consistently been in a 30-60 basis points over the past few years (100 basis points make one percentage point).

Investors in SDLs include provident and pension funds, banks and insurance companies.

Banks are not required to compulsorily invest in SDLs but they do invest in them as it fetches them higher yields than government bonds. There is also the comfort of RBI managing the borrowing. SDL auctions rarely go unsubscribed.

The RBI, in managing state government borrowing, makes sure that each state services its debt by placing money in an escrow account, just before the interest or principal is due.

There is not a single case of a state defaulting on its debt as the RBI is actively involved in ensuring that states service their debt. The RBI also closely interacts with the finance secretaries of each state to make sure states do not go overboard in their borrowing and budgets are more or less balanced.

A lesson for the ECB

The ECB, by following the RBI, will manage Italy's borrowing and make sure the country services its debt by placing money in an escrow account to fund its interest and principal.

The ECB can provide a temporary overdraft to Italy to tide over any problems in placing money in the escrow. The ECB can also interact with the Italian finance minister on Italy's borrowing and budget deficit to make sure the country does not go overboard on its finances.

The ECB should also treat Germany as the central government and all other member nations as state governments.Germany should also play its part as the strongest country of the eurozone by acting as a mentor and helping out troubled nations. The ECB will then ensure that nations get back on track and German taxpayer money is safe.

The ECB, by managing eurozone debt, will also bring down debt spreads between Germany and other nations.

The spread between Italian and German debt yields is currently 500 basis points. In contrast, the spread between an SDL and central government debt is 30 basis points. Italian bond spreads will come off sharply once ECB gets into the picture.

At the heart of the eurozone debt issue is that sovereign nations that have adopted the single currency are actually funding sovereign debt through external borrowing.

For example, Italy, which needs to borrow from the markets to service its large debt ($2.2 trillion), borrows in euros.

Investors in Italian bonds not only include Italian banks but also banks from other European and non-European countries.

Eurozone investors assume credit risk while buying Italian bonds, while non-eurozone investors assume the credit risk of Italy and currency risk of the 17-nation currency.

The central bank of Italy is the ECB (European Central Bank).If Italy is facing pressure on refinancing its debt, the ECB cannot help Italy by either buying its bonds or by giving the country an overdraft to tide over temporary liquidity problems.

Hence to Italy, the ECB is ineffective, as it cannot help Italy with its debt problems, which may well be temporary.

Italy also has an issue of demand for its bonds. Non-Italian borrowers have no compulsion to invest in Italian bonds and in troubled times, such borrowers will vanish, leaving a large demand-supply gap.

That demand-supply gap pushes up yields on Italian bonds, which was seen last week, when bond yields crossed 7% levels.

The new ECB president, Mario Draghi, started off with a bang by cutting policy rates. Now he can act to save the euro by taking on the task of managing eurozone debt, not by buying its bonds but by making sure each government acts responsibly. The RBI is doing it with 28 states, the ECB can definitely manage with 17 countries.

Arjun Parthasarathy is the editor of a web site for investors.

Your guide to the latest cricket World Cup stories, analysis, reports, opinions, live updates and scores on Follow us on Twitter and Instagram or like our Facebook page for updates throughout the ongoing event in England and Wales.

Updated Date: Dec 20, 2014 05:06:45 IST