Why sovereign bonds, as a remedy to cure India's fiscal weakness, isn't an exciting idea

The idea of the government raising debt overseas is novel because this has never been done before. The stance taken so far is that all government debt is internal (when foreign portfolio investments (FPIs) invest in the market it is in rupees) and hence theoretically the size of public debt does not matter because it is in rupees. Debt can always be serviced by printing more currency in the extreme case. The narrative is set to change now with the government borrowing probably $10 billion this year in overseas markets which are approximately Rs 70,000 cr or 10 percent of the gross borrowing programme. And this may be just the start and if successful can be done every year according to the requirements. [caption id=“attachment_1374421” align=“alignleft” width=“380”]  Representational image. Reuters[/caption] Such ideas did appear earlier too when there has been a forex crisis where a sovereign bond was considered for bringing in dollars. However, ultimately whether it was RIBs (Resurgent India bonds) or IMDs (Indian Millennium Deposits) or the swap arrangement on non-resident Indian (NRI) deposits, the government never raised bonds. It was done by either the banks or a guarantee provided by the Reserve Bank of India (RBI) in case of the swaps to banks on Foreign Currency Non-Repatriable account (FCNR) deposits.

The motivation for such an action appears to stem from the fact that liquidity has been a major issue in the system where it is progressively felt that the government is driving out or crowding out the private sector by borrowing a lot from the market. By diverting some part of the borrowing to the overseas market, space is provided to banks to lend to the private sector. This argument is convincing.

The other argument is that it can be a cheaper source of finance for the government which is borrowing at say 6.5 percent today in the domestic market. But this may not be so because while the US sovereign bond goes at around 2 percent, it is so because it is considered to be an AAA-rated country. When India is just on the edge of the investment-grade at BBB, the cost will be higher at least 3-3.5 percent based on how other countries with a similar rating are borrowing in the market. But investors won’t be happy with just such a return. As the rating moves downwards, they would look for some insurance cover too which is reflected in the CDS (Credit Default Swap rate) which for a BBB rated country can be another 150-170 bps. Italy, which has a rating similar to India, has a CDS of 150 bps for 5-years paper. Hence the cost can go to closer to 5 percent. To this must be added the forward cover that has to be theoretically included and the cost may be even higher than the rate of 6.5 percent reckoned in the domestic market. Therefore the argument of the cost being lower may not be true and is debatable. The third argument can be getting in dollars over time. It could be $10 billion today but progressively be increased to larger quantities as the appetite builds up. But on the other side it also adds to our external debt which today is dominated by the private sector. Hence, if the sovereign bond becomes a habit then the external debt situation will become a worry as it increases as it has to also be serviced. The absolute level of external debt is close to $550 billion and well above our forex reserves.

The concerns are very compelling here. The first is that once the government starts borrowing from outside, the credit rating becomes critical. While even today we get a rating from S & P, Moody’s and Fitch, the stance taken is that we do it just because we would like to have a rating which is not used by the government. The rating actually works for private companies that borrow as the country rating becomes a kind of ceiling. Now, once the government starts borrowing in global markets, the rating matters and in a way, we would be under the constant scanner as the CRAs would be looking at all activity very closely.

For example, they normally don’t accept the fiscal deficit ratio of 3.3 percent and add that of the states, PSU losses, off-budget borrowings and come to a much higher number. Further, any populist measure announced like waivers would be seen negatively and come in the way of rating. The sudden departures of important personnel of the central bank or the government would be viewed as risk factors.  It has been often argued that CRAs tend to indirectly dictate the policies that should be pursued – just like how the IMF and World Bank are known to do when loans are given. Therefore, in a way autonomy gets affected. From a market standpoint, sovereign bonds will mean more volatility in the markets. GSec market today is purely domestic and the yields depend on domestic conditions. The RBI can manage these yields by having regular Open Market Operations (OMOs) or getting the market makers to intervene. But this will slip away as Fed action in the US can drive the international yield on an Indian GSec which will then wind its way into the domestic system as arbitragers come in. Also, FPIs may prefer to invest overseas where the exchange risk does not have to borne unlike in India where they carry this cost. Hence volatility beyond the control of the RBI is possible. The same holds also in the forex market as the rupee will be more susceptible to international developments relative to fundamentals. On the whole it does look like that while experimenting the international markets is not a bad idea, continuous recourse to the global market to finance the fiscal deficit is fraught with dangers of becoming more obedient to the concerns of rating agencies besides having the potential to generate more volatility in the market as the yields get influenced by developments in other markets. External debt will increase for sure as will debt servicing, and FPIs may also choose between the two options. And lesser government paper in the market may not be a comfort for some banks which prefer to hold excess SLR securities to manage their balance sheets. (The writer is Chief Economist, Care Ratings)