A major highlight of the Union Budget 2019 was the government’s proposal to finance the fiscal deficit by overseas issue of sovereign bonds. Low external debt to GDP ratio and availability of cheap credit in global market has been put forward as the rationale for this initiative, but can the government consider raising fund overseas as a sound and reliable option?
Finance Minister Nirmala Sitharaman’s announcement of raising a part of gross borrowings in external currencies by overseas issue of sovereign bonds marks a structural shift in policy. It will be the first time the government will directly borrow in foreign currency to finance a part of its fiscal deficit. Currently, foreign debt comes in primarily by the way of FPI (Foreign Portfolio Investors) investments in domestic sovereign bonds, denominated in Indian rupee.
According to Economics Secretary Subash Garg, around 10-15% of total borrowings, i.e., around $10 billion can be raised through overseas bonds. The budget announcement was welcomed by the market as bond yields fell to 6.33% (on July 17), the lowest since December 2016.
A case of foreign sovereign bonds
Over-indebtedness to foreign markets isn’t an issue as India’s sovereign external debt is under 5% of GDP while external debt is only 21% of GDP (on Mar ‘19). A benign inflation rate well under 4%, steadfast stock of more than $425 billion forex reserves further justifies the timing of this decision.
With economic growth slowing down and domestic savings not increasing, Indian economy needs foreign money to stimulate growth.Raising external debt implies that government will seek less funds from the domestic bond markets which in turn will diminish the ‘crowding out’ of private borrowings, i.e., it will leave a larger pool of funds for private sector.
Is it the right time to borrow overseas? Interest rates are quite low globally after rate cuts from various central banks. The US 10-year treasury yield slid under 2% while the German 10-year bond yields went below -0.3% early in July 2019. Compared to domestic 10-year bond yields of around 6.5% and more, foreign bond markets seem cheaper prima facie but cost of foreign bonds must be analysed critically. Experts believe that countries with similar credit rating that of India can expect a basic cost of 3-3.5%. To offset the risk of default, lenders buy Credit Default Swap (CDS) from other investors who agree to reimburse the lender in case of default and in turn receives premium from the assured lender. To cover the cost of CDS, lenders will ask for a greater return than the basic interest rate. Furthermore, government will need to hedge the borrowings against forex fluctuation risk. After adding all such costs, foreign debt might not be that cheaper.
India’s sovereign credit rating will also play a deciding role in the cost dynamics. While Moody’s last upgraded India’s rating to Baa2 (a notch above lowest investment grade) Fitchhas kept it unchanged at BBB- for more than 12 years. A lower credit rating suggests greater credit risk, and greater risk demands greater compensation.
Moreover, this move can aid Indian sovereign bonds to get into global bond indices. The sovereign foreign currency borrowing rate could serve as a reliable benchmark for establishing a fair market price for Indian debt, helping other Indian firms price their issuance easily. Moreover, it can help to set up a credit default swap market for the Indian sovereign, which in turn would augment the liquidity and improve the pricing for all Indian debt overseas.
The domestic interest rates are mainly influenced by RBI monetary policy and the central bank can tweak the interest rates and to keep government borrowings cheaper. But in international financial markets yields are market-determined and highly vulnerable to global interest rates.
Former RBI governor Raghuram Rajan is strongly against sovereign external borrowings as he has listed multiple arguments why this idea is fraught with risks.
Firstly, if government wanted to tap into foreign savings that could have been done by raising FPI limits in sovereign rupee bonds, without taking up any exchange rate risk. On the contrary large investments in onshore debt by FPIs can destabilise domestic forex markets, liquidity and even equity markets at the time of global or domestic stress.
Secondly, sovereign external borrowings are vulnerable to exchange rate fluctuations. The benefit of cheaper interest rates in global markets might be nullified if rupee depreciates sharply over the maturity period of sovereign bond. However, rupee may not depreciate or even appreciate in case dollar inflows swell substantially. If India is able to boost Foreign Direct Investment in the economy – opportunity for which are plenty amidst a trade war – and maintain inflation rates at moderate levels, it might do just fine with managing the exchange rate risk. Moreover, foreign exchange reserves stand at a healthy $425 billion plus to safeguard against a steep downward spiral of Indian rupee.
Thirdly, Rajan said “the country should worry about short-term ‘faddish investors’ buying when India is hot, and dumping us when it is not.” “Hot” money is even now flowing in and out of stocks and bonds in domestic market. Nearly $260 billion of portfolio money is invested in stocks and debt, as of March 2019. If foreign investors were to dump Indian securities, the forex will dwindle irrespective of the limited issue of overseas sovereign bonds.
Furthermore, it is said that global bond sale won’t reduce the amount of domestic government bonds the local market has to absorb. The government will borrow more than Rs 7 lakh crore from the markets to finance its fiscal deficit of 3.3 percent of GDP in 2019-20. The bulk of gross borrowings will be raised from domestic markets (around 85-90%). As pointed out by outgoing Deputy Governor of RBI, Viral Acharya, Indian economy risks ‘crowding out’ of private borrowings due to high government borrowings. This indeed can defeat the purpose of issuing overseas sovereign bonds.
To conclude, it may not be a bad idea to finance a part of the fiscal deficit by floating sovereign bonds overseas. When pursued as a complementary source of borrowing, the associated risks seem subdued for a promising emerging economy like India. While the cheap interest rates abroad are luring, when approached with imprudence, the burden of indebtedness has haunted a few emerging economies in the past.
Hence, overseas sovereign bond shall be treated as part-time and limited source for funding the deficit. Long-term focus should be on stimulating domestic savings along with maintaining fiscal prudence.