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BIG BOND SCARE: How overseas sovereign bonds can make India vulnerable

Author: Kumar Shankar Roy/Wednesday, August 7, 2019/Categories: Exclusive

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BIG BOND SCARE:  How overseas sovereign bonds can make India vulnerable

About a month ago, finance minister Nirmala Sitharaman in her maiden Budget said India’s sovereign external debt to GDP is among the lowest globally at less than 5% and therefore the government would start raising a part of its gross borrowing program in overseas markets in external currencies. Initially, it was greeted with enthusiasm as the move to raise money from the global markets meant a big chunk of supply will vanish from the domestic bond markets and give adequate space for credit-starved Indian corporates to raise funds here. Every time a corporate taps the domestic bond/debt market, it competes with the RBI which sells the government's debt securities. But soon, skepticism crept in. Some fears were raised. Examples of defaults by Greece, Argentina, Russia and Ecuador were cited (see graphic). When a government borrows too much and cannot repay, it defaults. Unlike corporate debt restructuring, there is no mechanism for the governments to declare bankruptcy and therefore the only way to come out of such a situation is bailout from the IMF and austerity on the fiscal plans.

The move to borrow in dollars or any other foreign currency has ruffled many feathers. Sitharaman's proposal was criticised by former RBI governors' Raghuram Rajan and C Rangarajan. Some felt that such an idea would allow rich nations to dictate the country’s policies, while others termed it a "risky venture" given the ongoing trade war between the US and China. The debate cost one man his job. Former finance secretary S C Garg was reportedly ousted from the post for his stance on the issuance of sovereign bonds. His detractors argued that raising money via a sovereign bond sale in overseas markets would make India vulnerable to fluctuations in forex markets and heightens external sector risks. The sovereign bond sale plan has not been put on the backburner. Let us look into what's a sovereign bond and the implications of such bonds.

Sovereign Debt

Sovereign debt is a central government's debt. Theoretically, this debt can be denominated in foreign or domestic currency. Until now, the central government has been issuing sovereign bonds in local currency and only in the domestic market.

In the past too, the central government had fancied with such an idea, but never pursued it seriously. Sitharaman must have seen some reason in pursuing a sovereign bond sale in international markets. For one, India's sovereign debt is considered to be low. As of March 2019, it stood at $103.8 billion, 3.8% of the GDP. Initially, finance ministry sources reportedly talked about how the government is only planning to test the appetite. So, they would plan to borrow only a small portion. Maybe, 10-15% of the total borrowing offshore and that is Rs 70,000 crore or about $10 billion in tranches. $10 billion, one may ask? Well, that is a small portion. Let's do a comparison. NRIs send about $60-70 billion money back home. India's forex reserve is $430 billion.

Cost of Raising Such Debt

According to a report by Abheek Barua, chief economist HDFC Bank, the yield of the bond or the borrowing cost is dependent on three factors:

Creditworthiness: The issuing countries’ perceived ability to repay their debts.

Country Risk: External/internal factors like unrest and wars tend to jeopardize a country’s ability to pay (current account deficit).

Exchange Rates: In cases where bonds are issued in foreign currency, fluctuations in the exchange rate may lead to increased pressure.

At BBB- rating (India’s rating), average spread for 10-year bond (EMs versus US treasury) is around 175 bps. "While India’s credit rating is the same as Russia, the spread in case of India could be lower.

This is because investors could attach a scarcity premium to Indian bonds (first issuance from India and scarcity of supply of Indian sovereign bonds). In a nutshell, considering the full investment grade of India, the scarcity premium for India and the better external sector indicators, Indian sovereign bond could be priced in line with some of the better-rated countries like Indonesia and the Philippines. The spread for 10-year bond could be around 100 basis points in our view," Barua wrote in the report.

Risks: Real or Reel

When a government borrows too much and cannot repay, it defaults. Unlike corporate debt restructuring, there is no mechanism for the governments to declare bankruptcy and the only way to come out of that situation is bailout from IMF etc. and austerity on the fiscal plans of the government.

Most macroeconomic crises in emerging economies are related to forex. This is related to the level of indebtedness in foreign currencies. Examples are the Asian crisis of the late 1990s or problems in Latin America and Africa. India's own 1991 crisis had roots in 1985 when India began having a Balance of Payments (BoP) problem. By the end of 1990 in the run up to the Gulf War, the situation became so serious that the Indian foreign exchange reserves could barely finance three weeks’ worth of imports. Yes, the government came close to defaulting on its financial obligations. The situation was so grim that the government had no option except mortgaging the country's gold to avoid defaulting on payments.

But except 1991, India has been immune from major global macro disturbances. A key reason could be that India did not borrow abroad in foreign currencies. What is the latest attempt at borrowing money in forex? From an economic point of view, India is going through a rough patch. The sharp slowdown in auto sales, NBFC stress and recent disappointment with the budget has turned the narrative pessimistic.

Foreign Currency Debt Hedging

One of the concerns for sovereign bond sale is that volatile dollar/rupee rates will create huge costs in the long term. This is a fear not a real danger. Why? Every time a foreign investor invests in assets denominated in overseas currencies, they use hedging. So, sovereign bonds can use hedging. The 12-month onshore forwards premium is about 4-5%, usually. The government can cover 70-75% of its exposure to break even with the domestic cost of borrowing. The government could even practice a conditional event-based hedging practice and deal with the currency risks. By hedging against such risks, you always will know what is the loss you are potentially staring at. Of course, hedging costs make foreign borrowing a tad costlier than borrowing in domestic markets, but by paying a little bit extra the government will allow domestic corporates space to raise funds in India.

How Can Overseas Sovereign Debt Impact You

If the government borrows from overseas, it may cut the yield on government bonds in the domestic market. Since interest rates on financial products, including small savings track the movement in G-Sec yields, this can reduce interest rates on loans as well as savings. So, this would be a bane if you are saver but a boon if you are a borrower. It makes India vulnerable. It links us with the global economy, which is arguably not in a good shape.The impact of any global event could impact India. This means that returns on your investment in domestic stocks and debt may become more volatile. Three, if the government starts borrowing too much of forex debt, a potentially tough year could really give the government a big scare and that chill will be felt by you and me if the government decides to hike taxes and cut spending in order to manage its budget. (The author is a journalist with 14 years of experience)

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