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Sovereign bond: To issue or not to

Sovereign bond: To issue or not to

Sovereign bond: To issue or not to
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By Latha Venkatesh  Jul 15, 2019 7:22:00 PM IST (Updated)

The Indian government has decided to issue a sovereign bond that is it has decided to borrow in foreign currency. This overturns a decades-old self-imposed constraint, writes Latha Venkatesh.

The Indian government has decided to issue a sovereign bond that is it has decided to borrow in foreign currency. This overturns a decades-old self-imposed constraint. Before we examine the merits of borrowing abroad now, let us examine why all the Reserve Bank of India (RBI) governors and all previous governments United Progressive Alliance (UPA) and National Democratic Alliance (NDA) refrained from this path.

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Until the early nineties, India was a rather closed economy and not anywhere near investment grade, so the question didn’t arise. But we were witness to the long and deep trouble that Latin American countries went through since mid-eighties because of their excessive foreign borrowing and it was a situation India was determined never to get in.
Our approach to allowing foreign funds to buy Indian debt was also influenced by the 1991 balance of payments crisis when we ran short of dollars to pay an International Monetary Fund (IMF) debt. The resultant sharp devaluation of the currency and the IMF’s conditions for a new loan hurt the economy and our pride. Hence despite the overall liberalisation of the economy that was ushered in since 1991, neither the sovereign borrowed dollars, nor did it allow Indian corporates to raise foreign debt without explicit RBI permission.
This decision was reinforced by the severe crisis the Asian economies - Thailand, Malaysia, Indonesia, Philippines and Korea went through in 1997. They were victims of excessive debt exposure of their sovereign and their corporates to foreign funds.
The temptation for a sovereign borrowing emerged in India only in the early 2000s. In 2002 to be precise. Indian software companies were earning dollars hand over fist, crude was below $20 and the rupee was appreciating. Finance ministers Yashwant Sinha and later Jaswant Singh asked the RBI for advice. A working group of the RBI went into the issue, and in concert with the then Indian executive director at the IMF, advised against a sovereign bond. The government dropped the idea.
During tough times like the Asian crisis and the US sanctions after our Pokhran nuclear test, during comfortable foreign exchange flows from 2001 to 2008, through the tremors of Lehman and the later taper tantrum, RBI governors from C Rangarajan to Bimal Jalan to Y V Reddy to D Subbarao to Raghuram Rajan advised against foreign currency borrowing and the finance ministers of varied parties accepted this recommendation.
But now the government appears to believe things have changed. The argument appears to be that India now has an FRBM (Fiscal Responsibility & Budget Management) Act and inflation targeting central bank. India's macros now have sustainably improved and hence the time has come to avail of cheaper loans in foreign currencies. Let us consider all these arguments:
Firstly, is the loan really cheap? Today the US 10-year (a AAA paper) trades at around 2 percent. India's BBB- paper can cost around 3 percent. So it is optically cheaper. But this argument is incorrect because if the dollars are fully hedged, the cost will be higher than borrowing from foreign funds in rupees. If the loan is left unhedged, the final repayment, taking into account the rupee's historical depreciation rate, may be at least if not more expensive than a rupee loan. The proponents argue that historically India's inflation was 7.5 percent, but in the last 3 years (since we adopted an inflation targeting monetary policy) inflation has averaged 3.5 percent. Hence, assuming the inflation rate remains at 3.5 percent the rate of depreciation of the rupee will also be much lower than the last 10 years or last 60 years.
Now, it seems too premature to make this assumption. Pitting a 3 year average against a 60-year performance seems total premature. Already, Wholesale Price Index (WPI) food inflation is running at 7 percent and prudence will demand that we at least wait for a decade to see if inflation remains sustainably lower. If inflation indeed edges up, currency depreciation will inevitably follow and a foreign loan could get expensive by the time we repay.
As for India's fiscal deficit, even at the stated 6.5 percent, it is higher than peer group countries rated BBB-. The goal of bringing down central deficit to 3 percent has been pushed back by both UPA and NDA governments repeatedly, or the numbers have been fudged. Indeed if the extra-budgetary borrowing of states and centre is added, India's current deficit may be 7.5 percent of gross domestic product (GDP).
As if this is not enough the government lately is making it a habit of meeting a large part of its deficit from an ever-increasing RBI dividend which actually amounts to monetisation of the deficit i.e. the government spends more than it earns; RBI makes up the difference by printing notes.
Why are these deficit numbers so important? They are relevant because if an Indian sovereign bond is listed, any signs of higher inflation, higher deficit or higher monetisation will lead to bondholders dumping Indian bonds; Indian bond yields will rise and will consequently push up domestic yields.
Sometimes vulnerability may come simply because of global instability such as a middle-eastern war, a rise in crude prices or a general risk aversion towards emerging market currencies because of a default by one or some emerging economies as happened during the taper tantrum. At such times the impact on domestic borrowers right from the home loan borrower to the SMEs to the corporates to the state and central governments can be painful. Even without a sovereign bond, Indian yields are impacted by the global movement in yields but the impact is much less.
The more pertinent reason for the government to go for a sovereign bond now appears to be to prevent crowding out private borrowers. The argument appears to be if a part of the borrowing is taken to new borrowers outside the country, corporates within can borrow cheap and kick start growth. While this intent is noble, this may still be achieved without exposing India to the vulnerabilities that come with a sovereign bond. The government is probably impatient because the rate cuts from RBI have been slow and their transmission even slower. But things are changing. The RBI has already cut rates three times this year and with growth flagging, is poised to cut more.
The transmission was tough because banks' credit growth shot up due to the non-banking financial companies (NBFCs) while deposits were climbing slowly. But the credit-deposit gap will narrow as the NBFC crisis ebbs, and as credit demand falls due to slow growth. Cuts in bank deposit and loan rates will surely follow.
The other big disadvantage, if foreign funds are allowed to hold more Indian bonds, is to Indian banks. While foreign funds can dump Indian government bonds when they wish, Indian banks have to mandatorily hold 19 percent of their deposits as government bonds. So every time government bonds are dumped by foreign funds Indian banks bond portfolio will suffer losses. The RBI has hence long argued that greater foreign ownership of Indian government bonds must be dovetailed to bringing down the mandatory SLR ratio.
Also, India's current account deficit at 2.1 percent is not exactly low compared to peer emerging markets. And India's reserves accretion is not because we have a compelling basket of exports (like China or the Middle East does) but because of capital flows. Capital flows are typically fickle and by definition prone to profit-taking. Indeed at the current juncture, a sovereign borrowing may merely result in reserve accretion with RBI being dumped with the task of managing the additional currency risk.
Lastly and most importantly, the global financial markets are far more uncertain today with longstanding trading arrangements getting challenged and growth models disrupted. To go for foreign currency borrowing at this stage may prove costly.
However, since the issue has been raised, it may be a good idea to debate it nationally and have a committee of respected economists and policymakers examine it. Like the Tarapore Committee on capital account convertibility, this committee can set macro benchmarks that we need to achieve. It can dovetail the amount of foreign borrowing (in rupees and foreign currencies) to certain macro indicators like current account deficit, fiscal deficit and inflation.  Such a committee may also examine if it is wiser to open the window for foreign portfolio investors (FPIs) buying rupee-denominated government bonds rather than issue a foreign currency bond.
India has suffered for too long from high deficits and inflation for us to conclude these problems are behind us. It is best to tread with caution.
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