After Finance Minister Nirmala Sitharaman proposed that the Indian government would borrow some of its funds in overseas markets in foreign currencies, there is a lot of buzz on sovereign bonds. It has been a fiercely-debated issue with a lot of highly economists. Even former Reserve Bank of India governors and deputy governors, mostly arguing against such an issuance. To top it all, now, there are news reports suggesting that Finance Secretary Subhash Chandra Garg was transferred to the power ministry because the government was unhappy with his handling of the sovereign bond issue. Here’s a FAQ on sovereign bonds.
What are sovereign bonds?
These are government debt securities issued in overseas markets in foreign currency denominations such as dollars, euros and yen. Currently, the government of India only issues bonds in the domestic market in rupees to finance the deficit between its expenses and revenues.
Why is it a big deal?
India has never resorted to large scale foreign currency borrowing even during the time of the 1991 balance of payments crisis. Thus, a sovereign bond issue now will represent a major shift in policy now.
What’s the need for a policy shift now?
The huge amount of government borrowing has put pressure on local interest rates and the availability of funds for the private sector. This is called the crowding out effect. For fiscal year 2019-20, the government plans to borrow at least Rs 7 trillion from the Indian markets. It is believed that shifting some of this borrowing abroad will relieve the pressure on local interest rates.
Secondly, as the finance minister pointed out, India’s external sovereign debt to GDP ratio at 5 percent is among the lowest in the world. Thus, there is room to borrow more.
Are there other benefits as well?
Well, there are a host of other possible benefits if India floats a formal sovereign bond in foreign currency.
One, rates for foreign currency borrowing in overseas market is cheaper. (There is a caveat here, we will come to it later).
Second, if Indian government bonds are included in foreign bond indices, it will make it more attractive. It will also set a benchmark for corporate foreign bond yields and also help attract more foreign investment.
Three, this could make the Indian government more disciplined in reining in the fiscal deficit. Foreign borrowers are quick to exhibit their displeasure if things go awry (this option is not here locally since banks are mandated by law to invest a portion of their deposits in government bonds).
Four, some commentators have pointed out that when sovereign bonds actually start trading, this will establish the credit risk premium for India. (Credit risk premium refers to the additional yield demanded by investors for investing in an emerging market like India compared to a mature market like the US). This could force credit rating agencies to improve India’s ratings once a baseline has been established. They point to Philippines and Indonesia where this has actually happened, to bolster this argument.
Sovereign bonds sound good. Let’s float them already?
There are lots of negatives too. Why do you think India has never gone for these instruments in a significant way?
The big problem is, of course, that the foreign currency risk (which an investor bears since if the bond is in rupees) will not be shifted to the government – it borrows in dollars now. That means, if the rupee depreciates sharply, the government ends up paying more. This could lead to even more market turmoil, points out former RBI governor Raghuram Rajan.
Secondly, India is still vulnerable to global economic risks because of the twin deficit problem. The fiscal deficit is high. While India does have a glide path to reduce the fiscal deficit, most governments have had a tough time in sticking to this goal and have resorted to fudging numbers. Indeed, the gross public sector borrowing – if one includes the centre, states and government-owned enterprises – is close to 8.5 percent of GDP. The current account deficit is also high and could even go up further in case of an economic revival through increasing investment demand. (If investments exceed savings, it has to be financed by foreign borrowings). These are big risk factors.
Thirdly, as some commentators have pointed out, on a currency-hedged basis, it is one percent more expensive than local currency debt.
Fourthly, once the tap is opened, there is a real risk that governments might get addicted to this form of funding. As former RBI governor YV Reddy has argued, unless a limited liability company, government debt is held in perpetuity. There is no write-off of government debt when times are bad. Moreover, all governments are liable to pay off debts incurred by their predecessors notwithstanding whether they were democracies or despotic regimes.
Moreover, if the idea is to get a global benchmark for corporate debt, an issue by a quasi-sovereign entity like SBI would be good enough, it is argued.
What’s the takeaway then?
In small quantities, sovereign bonds in foreign currencies won’t probably be harmful. But, the big question remains whether governments will stick to these small portions and whether that is good enough to get some of the theoretical benefits.