Stimulating the economy: measures and methods

Buzz on sovereign bonds has risen after the Finance minister’s proposal of borrowing money in overseas markets in foreign currencies. A heated debate is going on with most of the economists and former reserve bank governors are putting arguments against the issuance of such bonds. Deep trouble of Latin American countries, Asian counties during the financial crisis have made our previous political leaders and bureaucrats stay away from foreign money in foreign currency. Most of those economies went into trouble because of their over excessive borrowings, which we never got into. We were also able to withstand the Lehman crisis, global slowdown partly because of our good decision to avoid foreign money in foreign currencies. 1991 The Balance of payments crisis has changed our approach and we allowed foreign funds to buy our Sovereign debt. We have opened our economy in early 90s after the introduction of game-changing budget by Dr. Manmohan Singh, which has opened gates for global money and helped to get investment ratings in global markets. Despite liberalization, our government or companies did not borrow in dollars without RBI permission.

With the change in global economic conditions and strong inflation-targeting central bank, FRBM act, and fiscally prudent government in place, one may assume that the FMs announcement can also be a game-changer and has removed our self imposed restriction of borrowing from abroad. Currently, we are issuing rupee-denominated bonds in local market to finance our revenue deficits, which is slightly costlier. Now the government is planning to issue sovereign bonds in overseas markets in global currencies such as dollars, euros, yen and British pounds. Factors like stable domestic macros, US 10yr treasury yields at 2.00% to 2.50%, and foreign money looking for higher returns will help us to avail cheaper loans in foreign currencies. Moreover, higher real interest rates, stable currency will trigger demand for our bonds by foreign portfolio investors. The finance minister pointed out our external sovereign debt to GDP ratio is around 5%, and placed lowest among the world, thereby opening room to borrow more.

Emerging economies in their growth phase, require of lot of capital and domestic savings, are low and not sufficient to fund the same. Hence, we need some foreign savings to fund our growth. At the same time, huge borrowing by Government is putting pressure on local interest rates and availability of funds for private sector and hurting the growth. Foreign borrowing is one of the easier routes to fund capital expenditure or to reduce the deficit burden. For the current financial year, we are planning to Borrow around Rs 700,000 crores, borrowing partly from abroad will reduce the pressure of local interest rates and also increases the liquidity availability into the system. Though intent is noble and may be achieved without much vulnerabilities that can come during the tenure. For now, our weightage in global debt market indices is very minor compared to other emerging economies and borrowing from global markets will facilitate the inclusion of our government bonds into global bond indices, which in turn will lead to higher foreign flows into India. Once bonds start to trade on the global platform, the credit risk premium will be established and can also improve our rating as a baseline is set. Ratings of Philippines, Indonesia and Malaysia have improved post-issuance of global bonds in global currencies.

Currently US 10-yr bond trades around 2%, and our highest-rated BBB-paper may yield around 3%. Hence one may feel they are available at lower cost if the borrowings are unhedged. As per the Bloomberg survey, the proposed USD 10 billion issuance is expected to list at a premium of around 90 to 130 basis points. If the loans are unhedged, based on the historical currency depreciation rate, we may end up paying almost equal cost of the local borrowings. On the flip side, if loans are hedged for currency volatility, the cost of borrowing may be higher compared to local borrowings. Moreover, Global participants are very sensitive and dynamic in nature; they are very quick in exhibiting their displeasure if things go out of control. Our governments have a habit of failing to stick on to fiscal discipline target; our historical inflation average is around 7% (though it was under control in recent years). If any of the above assumptions go wrong and move against us, the currency will depreciate and can make foreign loan expensive by the time we repay. We need to keep our key macro indicators under control so that the current low cost of borrowing is in place till the maturity. All the above parameters are most important, as any indications of inflation inching higher or higher deficits will lead to bond selloff triggering a rise in domestic bond yields as well.

Global currencies denominated bonds are highly sensitive to global interest rates, any global shocks like in 2000 / 2008 / 2013 can lead to exaggerated selling pressure into Bonds. Sometimes uncertainties may arise from global unstable events such as trade wars, a spike in crude oil prices or even risk aversion towards other emerging markets due to rub-off effect of default by one or other emerging countries that happened earlier. Though foreign player’s investment in our debt is around 4%, which is way below when compared with other emerging economies. However, RBI must exercise caution before opening up the limits for foreign players or borrowing money from global platforms. Most of the time RBI needs to intervene to minimize distortions in currency and sovereign bonds. The government should be more prudent and disciplined while resorting to these sorts of borrowings. It should not get addicted to this form of borrowing and funding investments or close the revenue deficit gap. Government debts are perpetual, and write off option is available during bad times. Future governments will be liable to pay off debts incurred by preceding regimes.

During turbulent times, the impact will be there for domestic borrowers from MSME to retail loan borrowers to state and central governments, where interest rates may spike which may be painful for all stakeholders. As a part of regulatory requirements, Indian banks generally hold 19% as government bonds till maturity, and selling by foreign players will spike bond yields and result in losses. Though in the long run, the difference between the costs of borrowing in local currency versus foreign currency is very minuscule, but the essential framework is required to address different scenarios of macroeconomic risks. Strict rules and limits must be placed in terms of macroeconomic stability parameters (Like Fiscal deficit, CAD, inflation), how much we will borrow on total, how much we will borrow on annual basis, how much outstanding will be kept, how much percentage of forex reserves will be as outstanding debt. Statutory backing has to be there for entire borrowing to reduce the risk. A proper hedging mechanism should be in place for currency swings. Even on the off-budget spending transparency has to be maintained, so that fiscal deficit is under check. Measures like capping the holdings of sovereign bonds by overseas investors to around 5% to 10% may reduce the risk.

RBI has already reduced its key interest rates by 75 bps and has signaled more to come, but the Government is already impatient on the process of transmission of rate cuts. Hence is in the process of boosting the economy through various stimulus measures. Going forwards, impact across asset classes will vary post-issuance and subscription for these bonds, while we assume it is neutral to positive for bond and forex markets. We have already seen cheer in Bond markets with bond yields trading near 6%, while financial markets reaction will depend on the usage of the borrowed money. Small quantities of foreign borrowings may not be harmful but sticking to discipline is key for long term economic well being.

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Professor Syed Hasan Jafar has over 10 Years of Experience in the field of Finance and worked as a Research Analyst and Corporate trainer. He comes on several national media channels as a financial expert for sharing his view on the financial market. His areas of expertise are Security Analysis, Corporate Finance, Equity, and Derivative Research and Wealth management. He completed his bachelor’s degree in Science from the University of Bangalore, his post-graduation Diploma in management from the Institute of Public Enterprise (IPE). He is NISM Certified Research Analyst. His areas of expertise are Security Analysis, Corporate Finance, Equity, and Derivative Research and Wealth management. He has conducted more than 50 Investor awareness programs across the country and has been awarded Best Research Analyst several times.