Macroeconomics

Why external sovereign debt should be avoided

  • Blog Post Date 29 July, 2019
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The Finance Minister of India, in her 2019 Budget speech, announced the government’s intent to finance a part of the fiscal deficit by issuing sovereign bonds in the international financial markets. This is a major departure from a 72-year history of Indian economic management when external commercial debt was consciously avoided by the government. In this post, Dr Pronab Sen discusses the arguments made in favour of issuing foreign currency-denominated sovereign bonds, and contends that such debt should be avoided.

 

In her Budget speech for FY 2019-20, India’s Finance Minister announced the government’s intent to finance a part of the fiscal deficit by issuing sovereign bonds in the international financial markets. This is a major departure from a 72-year history of Indian economic management when external commercial debt was consciously avoided by the government.1 There appear to be three main arguments that have been made in favour of issuing foreign currency-denominated sovereign bonds in the international market:

(a) Foreign interest rates are much lower than interest rates in India, which would reduce the government’s future interest payments;

(b) Yields on our sovereign bonds will set a benchmark for Indian companies to raise funds abroad; and

(c) Space will be created in the domestic financial market for the private sector by reducing ‘crowding out’.

We consider these in turn.

First, it needs to be realised that the interest rate on the sovereign bonds will depend upon the sovereign rating of the country by rating agencies. At present, India’s rating is already at the bottom of ‘investment grade’. Since India has never borrowed abroad commercially, these ratings are currently of academic interest, and are designed mainly to provide guidance to foreign portfolio investorsand to influence policymaking in India (which has worked up to a point). However, if India does decide to float a sovereign bond, there will be a re-rating; and these ratings will be real in the sense that they will determine the actual interest rate that we will have to pay. 

As things stand, the rating agencies are aware of the fact that the numbers presented in the Budget are not entirely reliable.3 In the last year alone as well, Government of India’s debt liability is understated by Rs. 1.6 to 2.4 trillion. This factor will not only be taken into account, but it will also be presumed that the proceeds from the dollar bonds would be used to pay off a part of this liability rather than for any productive purpose. It is then almost certain that the re-rating will tip our sovereign rating to ‘junk bond’ status. 

Such an outcome will not only involve serious loss of face for the government and the country, but the actual interest rate will not be the 2% that is being talked about, but closer to 4%. If hedging costs are taken into account, these will add another 3.5-4% to the rupee value of the interest rate. Thus the total rupee value will be around 7.5-8%, which is significantly higher than the current yield on 10-year government bonds (6-7%). Of course, the government can choose not to hedge its interest liability and bear the exchange risk, which will lower the actual pay-out if the rupee does not depreciate significantly. 

Second, as far as external commercial borrowings by Indian companies are concerned, it needs to be mentioned that such borrowings are already US$30-40 billion annually. Do we really need more, especially when our balance of payments is not stressed because of foreign direct investment (FDI) and foreign institutional investment (FII) inflows? More importantly, the presumption that a sovereign bond yield will help reduce the interest rate paid by our companies may be misplaced. At present, since no sovereign yield exists, Indian companies are borrowing abroad on the strength of their own balance sheets and, to a lesser extent, India’s foreign exchange reserve holdings. As a consequence, many companies are borrowing at rates which are lower than the rate which will be applied to a sovereign ‘junk bond’. However, once a sovereign yield comes into existence, foreign lenders will find it very difficult to justify lending to Indian companies at interest rates lower than the sovereign yield. As a result, the better Indian companies may actually experience an increase in their rates and not a reduction, as is being hoped. On the other hand, weaker companies may find it easier to borrow, but since they cannot avoid hedging, it is quite likely that their rupee cost of foreign borrowing may be higher than the rate they pay on domestic borrowings.

Third, while it is undoubtedly true that a reduction in the government’s domestic borrowings will free a certain amount of domestic financial resources for private borrowers, it does not in any way increase the quantum of domestic savings. If the Indian private sector actually borrows more, it will create a gap between savings and investments in the country. This can only be bridged by an increase in the inflow of foreign savings. Since, by definition, inflow of foreign savings equals the current account deficit (CAD), it will require the CAD to rise. The real question is whether this takes place through increased economic activity in the country leading to an increase in the import bill or through a reduction in exports, which would depress economic growth.

The most likely effect will be that shifting a part of government’s borrowing abroad will almost immediately lead to an upward pressure on the rupee. While this may hold down the rupee cost of government’s interest payments, it will make the Indian economy less competitive in the international markets: exports will tend to decline and imports rise. The trade balance will certainly worsen and so also will the CAD.  On the other hand, this may encourage greater FII inflows, since rupee appreciation will yield capital gains to them. This will no doubt help the balance of payments position, but at the cost of higher external vulnerability of the Indian economy. This is also an unstable situation since the government may be tempted to continue to borrow abroad because of the lower cost, thereby perpetuating a cycle leading to higher and higher external indebtedness of the country.

Finally, and perhaps most importantly, external sovereign borrowing involves serious loss of sovereignty and of policy independence. This has been the experience of many countries in Latin America and even in Europe. It should be realised that foreign commercial lenders have interests that are very different from those of a democratic government, and will push the country’s policies in directions that suit their interests. Some of this happens even today through the influence that rating agencies have on FIIs. However, this impact is limited and is becoming less so over the years as FIIs have become more familiar with the Indian economic system. It may be argued that the amount of funds that will be raised is so small (US$10 billion) that it will not materially change the current position. While ‘testing the waters’ may sound reasonable, but once this door is opened, future governments may find the short-run attractiveness too hard to resist, which can then lead to serious long-run problems for the country. 

This article represents the personal views of the author and not necessarily those of the organisation to which he belongs.

Notes:

  1. Up to now, external borrowings by Government of India have been limited to multilateral agencies and bilateral arrangements with foreign governments.
  2. Commonly known as foreign institutional investors (FIIs) in the Indian parlance.
  3. A recent report by the Comptroller and Auditor General (CAG) estimates that in 2017-18 the fiscal deficit was underestimated by around 2% of GDP (gross domestic product) if off-Budget items are taken into account.
  4. The 2% figure comes from the interest rate paid by the US government on its dollar borrowings. Those who use this number forget that US sovereign debt is the only risk-free instrument for dollar-denominated borrowings. All other countries will have to pay a higher rate since they will carry some risk: for the good ones, it may only be market risk; for the others, there will be default risk as well. 
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