By Puja Mehra
Nirmala Sitharaman has become the first Indian finance minister to agree to borrow in foreign currency to finance the fiscal deficit. After she announced this in her maiden Budget speech last week, economic affairs secretary Subhash Garg added that the plan is to raise up to 10-15% of government borrowing — $10 billion — from the first overseas sovereign bond. In all, central government plans to borrow a record Rs 7.1lakh crore this year.
The shift in India’s position comes in wake of the main pool of savings from which the rest of the economy raises debt, the households’ financial savings, getting almost completely pre-empted by the growing borrowings by the government and public sector.
If GoI could free up some of this borrowing space, more resources will become available for financing private investments, and supporting GDP growth that is slowing down. Unsurprisingly then, North Block is desperate to ease the pressure of its growing borrowings on domestic debt markets, and has dismissed those cautioning about the risks of dollarisation of the sovereign debt as needless orthodoxy.
Can raising foreign currency denominated borrowings to finance general government rupee expenditure and the deficit, rather than a specific objective, be problematic? One of the potential positives being extolled is that with the pressure easing off in the domestic debt market, the cost of borrowing for GoI would reduce.
Sure, the cost of the rupee debt may reduce, but the rupee cost of the borrowings in dollars will depend on the currency risk, including hedging costs. If the rupee depreciates by the time of redemption of the foreign currency-denominated sovereign bonds, the rupee cost of this debt will rise.
The ceiling of such issuances remaining under 10-15% of total government borrowings will then come under strain, as the temptation in North Block would be to take recourse to more and more foreign currency-denominated sovereign bond issues to keep paying for higher costs owing to rupee depreciation.
In other words, the real risk of the ‘magic bullet’ is that the currency risk could be significant and, as a result of that, foreign currency-denominated sovereign can easily become a self-perpetuating cycle, with fresh issuances getting floated to cover up for the fiscal impact of higher redemption costs in rupee terms owing to depreciation of the rupee of past issues.
The bureaucrats pushing the idea right now to make up for tax revenue shortfalls would have retired by then, leaving it to the rest of the economy, especially future generations of taxpayers, to cope with the rising fiscal costs.
An added complication is that the foreign currency raised will need to be converted into rupees by Reserve Bank of India (RBI). Now, whenever RBI buys or sells foreign currency, there is an impact on the rupee supply. When RBI buys foreign currency by paying in rupees, it creates and infuses fresh money into the system.
This is precisely what happens whenever there is an increase in net RBI credit to GoI. Rupees get created and are infused into the system. In the process, money supply increases.
One of RBI’s responsibilities is to provide a sort of overdraft facility to the government through ad-hoc treasury bills that have to be redeemed in 91 days. It is meant to allow the government to get over temporary mismatches between receipts and expenditures. But in the pre-1991-era, such issuances were the norm, not the exception.
GoI enjoyed recourse to limitless money at concessional rates. The rate of interest charged on this credit from the mid- 1970s to the 1990s remained at 4.6%, below the prevailing market rate. RBI printed money to finance successive governments’ populism.
Instead of getting determined chiefly by the level of economic activity, the quantum of money getting created was virtually dictated by the government’s needs for its Budget.
As a large proportion of the money getting created in the economy and its cost were outside its discretion, the fiscal dominance constrained RBI’s ability to conduct monetary policy.
With the market orientation of the economy in 1991, and the subsequent reforms introduced, the fiscal-monetary relationship changed. RBI has had more discretion for creation of money as distinct from GoI, the authority for spending the money.
Foreign currency-denominated sovereign bonds, however, will once again ensure that RBI will have to print rupees to the extent of GoI’s borrowings in foreign currency. Just as it did in the pre-1991-era. That is the real danger of this idea.
This Calibrated Plan May Work-
By Amarendu Nandy
GoI’s plan to issue sovereign bonds abroad is leveraged on the premise that India’s sovereign external debt to GDP is among the lowest in the world ($103.8 billion, or 3.8% of GDP, and 19.1% of total external debt in March 2019). As long as global investors continue to find credibility in the India growth story, there is headroom to augment such overseas borrowings now.
Though GoI has advanced the vision of becoming $5 trillion economy by 2024 driven by a ‘virtuous cycle of investment’, such an approach needs to be supplemented by expansionary, but responsible, fiscal and monetary policies.
Deficit financing through resources garnered in domestic markets can put considerable strain on loanable funds available to private investors, increase the cost of capital further, lead to a crowding-out effect. This assumes significance when the gross savings to-GDP ratio has exhibited a secular decline, from 34.6% in 2011-12 to 30.5% in 2017-18.
Sovereign external borrowings, while financing a part of the deficit, can substantially ease the upward pressure on domestic interest rates, free up domestic loanable funds, crowd-in private investments, and provide the much-needed impetus to domestic production. It shall make immense sense to raise foreign savings at competitive rates, rather than thrust additional demand on scarce domestic savings to finance the deficit.
Even with the Fiscal Responsibility and Budget Management (FRBM) Act, 2003, successive governments have failed to adhere to the recommended glide path of deficit targets. The plan to mop up substantial revenues through the sale of sovereign bonds can only be successful if GoI takes up concomitant reforms to reign in fiscal profligacy.
Foreign investors usually base their investment decisions on the government’s demonstrated ability to tread the path of fiscal prudence, consistent with its objective of debt sustainability. Assuming the plan is not a one-time exercise, such a step can help enforce fiscal discipline and restore the credibility of fiscal policies.
A2015 IMF study on international sovereign bonds by developing economies concluded that countries with strong fiscal and external positions, and strong government effectiveness, mattered for successful bond issuance, market access and for lower bond spreads. With the current account deficit (CAD) at a manageable 2.1% in FY19, share of government debt to GDP hovering around 68-69% for the past several years, forex reserves at a historic high of $427.7 billion, the economic bandwidth may be just right to get into the global sovereign bond market.
YoY fiscal slippage is still an area of concern. India’s sovereign ratings have been upgraded to investment grade Baa2 by Moody’s in November 2017, the first upgrade since 2004. This shall significantly impact the demand and rates for the sovereign Indian paper.
Current global debt market conditions may turn out to be relatively favourable for India, as bond yields in the developed markets have plummeted to record lows. Estimates suggest that around $13 trillion of bonds have negative yields.
In such a scenario, India’s benchmark yield at around 7% and a relatively stable currency should help attract a sizeable amount of inflow into the domestic debt market from a diverse set of investors, and aid Indian sovereign bonds to get into global bond indices. The sovereign foreign currency borrowing rate could serve as a useful benchmark for external commercial borrowings as well.
Concerns have been raised, including by former RBI governor C Rangarajan in his paper, on the rationality of raising sovereign debt in foreign currency rather than in local currency. Borrowing in foreign currencies may expose the economy to undue exchange rate risk, particularly in the event of a depreciation. On the other hand, India can simply inflate their way out of debt obligations when denominated in local currency.
In this context, a March 2018 Bank for International Settlements (BIS) study, which covered 73 emerging economies, found that the average difference in the average local currency rating minus its foreign counterpart that used to be as large as three times in 1996, had almost fully closed by 2015.
It concluded that higher forex reserves had the greatest explanatory power to explain the trend decline of the gap among emerging market economies. Also, it found no support for the often-cited hypothesis that high inflation might increase the relative creditworthiness of local currency obligations.
Given India’s strong international reserve position and stable macroeconomic fundamentals, the calibrated plan to raise about 10-15% of total borrowings through the overseas bond route carries minimal downside risks, and is a step in the right direction.
(The writer is assistant professor, IIM Ranchi)